US and European regulators and lawmakers have been calling in recent weeks for measures to bring regulation and transparency to the credit derivatives market.

A credit derivative is a type of insurance contract designed to protect against losses linked to bonds, loans or other debt instruments. The way it works is, in theory, very simple: if one bank lends to another bank, that lending bank can, through a credit derivative contract with a third party, insure itself against the risk that the borrowing bank will fail to repay that loan. The price of this insurance is derived from the credit risk on the underlying loan or similar debt instrument (hence the name). The firm or other institution to which the loan is made for which protection is being bought is called the “reference entity”.

The most common form of credit derivative – the one in the news of late – is the credit default swap, or CDS. Here, the buyer of the insurance makes periodic payments to the seller in exchange for the right to a payoff if what is known as a “credit event” occurs – namely if the reference entity files for bankruptcy, undergoes restructuring or for one of several other specific reasons fails to honour its debt to the buyer of the insurance.

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