To begin the explanation just wanted to quote some of the financial baron’s views on CDS:

In 1993 George Akerlof Nobel prize-winning economist predicted that the next meltdown will be caused by the CDS.

In 2003 Investment legend Warren buffet called them as weapons of mass destruction.

Man behind the Subprime crisis Former Fed Chairman Alan Greenspan – betted big on them as cheerleaders !! now quote CDS are dangerous.

A leading paper news week described CDS, The monster that ate Wall –street.

The Guru of credit derivatives Satyajit Das quoted that CDS will not stabilize the economy rather could lead to destabilization

CDS contract are dangerous because they can be manipulated for mischief: buy a CDS, than naked short the credit to death. It’s all about the insurable interest which is never there as it is used for speculation. A derivative that amounts to an insurance contract with no insurable interest is bad. But do the speculators have insurable interest?  No never!!

The CDS contracts that caused the mess were just such contracts. The problem was not that they were “derivatives,” but what kind of derivatives they were.

I got the chance to grab the 81 page draft report of the internal group on the Introduction of Credit default swaps for corporate bonds. Basically CDS is a credit derivative that can be used to transfer credit risk from the investor exposed to the risk called protection buyer to an investor willing to take risk called protection seller.

Its been more than a year now the CDS market is active in India. For dealing in CDS both the counterparts specify a reference entity, reference obligation (mortgage, bonds,) notional amount, credit events. In India the internal group has favored launching of CDS only on corporate bonds.

As per the report the eligible participants are commercial banks, Primary dealers, NBFCs, (Insurance companies and Mutual funds notified and clarified by IRDA and SEBI)

In the Indian context the CDS could turn out to be hedging tool, but the market maker will be speculating on the product. Enormous amount of money will be deployed in making and marketing the prospectus so a huge commission is on the cards for the sales team.

The biggest risk involved with the CDS is that it can lead to systemic risk and could lead to contagion which will in fact derail the whole financial system. That we can infer from the Sub prime and the European crisis.