CDSs, like so many things in the world of finance, involve risks. There are two types of risk in particular that you need to understand if you are to understand what’s going on in the world of finance and how these risks could blow the whole economic system we know and love sky high.
The two types of risk are counterparty risk and third-party risk.
You and your new colleague Dave, who works in the compliance department, have decided to go for a drink. You pay for the first round of drinks, but when it comes time for Dave to buy the drinks he notices that he has left his wallet at the office. You’re both having a fine and dandy time of it, so you agree to pay for a few more drinks and Dave agrees to pay you back when you see him in the office the next day.
As you order another round of drinks you think to yourself ‘No problem, Dave works in the compliance department, he’s as honest as the day is long’. You both have a few more drinks and then go your separate ways. You, comfortable in the knowledge that the next day you’ll get your money back from honest Dave.
Unbeknownst to you Dave is a degenerate gambler. While you were in the bathroom Dave had called his bookie and placed a rather large bet on one of those silly games they like so much across the pond in the land of the free and the home of the hamburger, that game they call basketball.
In his infinite wisdom Dave had bet on his favourite team The New York Knicks. Unsurprisingly, just like 32 times prior this season, the Knikcerbockers of New York lose and Dave is out of pocket.
The next day Dave is not in the office. He’s jumped on the first EasyJet flight to Mallorca to escape his bookie and drink himself into oblivion. No money for you.
You, my friend, have just been on the receiving end of counterparty risk. You (party A) had made an agreement with Dave (party B) concerning a debt (based on the price of drinks consumed) to be repaid at a future date (the next day). Party A believed party B would be able to make good on its debt, but when time of payment arrived party B was not forthcoming with the necessary funds. Result: A realised counterparty risk.
Let’s go back to our example of you and Dave, but this time Dave is not a degenerate gambler. In fact he has inherited a fortune from his aunt and despite being a millionaire he remains frugal in his ways with no secret vices, unless you call enjoying a few drinks in intellectually stimulating company a vice.
The next day you go into your office and there’s Dave standing by your desk looking pale, rubbing his palms together nervously and shifting from foot to foot.
“Good morning Dave, you’re not looking too good. Hangover?”
“It’s the bank" Answers Dave
“Bank?” You query
“My bank” replies Dave
“Your bank?” you clarify your original question
“Yes, my bank” retorts Dave
“What about your bank?”
You get frustrated at the lack of progress and clarity with this conversation and try a new tack.
“Dave, I’m not sure I quite follow you. Can you just come out and say it, please?”
“My bank has gone bust. Thy diversified into bitcoin, oil and did some acquisitions in Russia, it’s all gone!”
The result is that you, my friend, have been on the receiving end of third-party risk. Despite having been flush with cash, Dave had (understandably) trusted his money to a third-party (a bank), which Dave had been dependent on to carry out his obligations.
Third-party risk is one of the most difficult to calculate. In any financial transaction, when you look at the complete chain of entities involved, it can become impossible to calculate the overall risk. In any future financial crisis, third-party risk is likely to play a significant role. A role we will only work out, after the fact.