The proliferation of credit default swap (“CDS”) contracts prior to the financial crisis drew the attention of scholars, regulators, and the public. In simplistic terms, credit default swaps enable contracting parties to tailor their exposure to credit risk. Credit default swaps occur when the “protection seller” agrees to compensate the “protection buyer” in the event the debt issuer—the “reference entity” or “underlying”—experiences a credit event. Credit events are “contractually defned performance triggers that determine whether a protection buyer is entitled to compensation ”. The term “credit event” can include events other than outright nonpayment. For example, the parties to a CDS contract may defne a credit event as having occurred when the reference entity experiences “a credit rating downgrade ”. In that case, the protection buyer in the CDS derivatives contract will be entitled to compensation if the reference entity experiences a credit rating downgrade. If the reference entity does not experience a credit rating downgrade, the protection seller will proft off the premiums collected during the life of the CDS contract. The function and structure of CDS contracts therefore can allow creditors to place a suffciently large bet against their own loans or bonds to proft from the failure of the debtor. For creditors that are “net short,” the debtor’s failure provides them with a payoff that can offset a loss on the underlying investment.
In 2019, ISDA circulated proposed changes to the standard CDS contracts, while the SEC, CFTC, and FCA released a joint statement on opportunistic strategies in CDS markets. The statement acknowledged the danger of manufactured defaults, expressing that they negatively affect the integrity, confdence, and reputation of CDS markets. Failing to announce any direct actions, these agencies implicitly delegated the problem to ISDA to solve. This paper seeks to (1) illustrate exactly what harms are created by engineered transactions, (2) identify which forms of engineered transactions are the most harmful, and (3) provide reasonable solutions to the problem of engineered transactions that are narrowly tailored in addressing those specifc harms.
Unraveling Credit Default Swaps–Engineered Transactions and Their Impacts
6 Sep 2025