Based on figures from Thomson Reuters, the financial crisis had the following impact on capital markets in 2008:

As a result of market volatility, public companies are seeking to raise capital in a much tighter time frame. There is an emerging practice whereby certain eligible issuers who already have an effective shelf registration statement on file with the SEC bring a limited number of potential investors "over the wall" to market a deal before announcing the deal publicly.

This means they provide these selected investors with material non-public information and make oral offers to sell securities, before they actually announce their intent to make an offering to the public. This eliminates the risk of announcing an offering when there is insufficient market appetite because the issuer has effectively already sold the deal before it announces it (the time frame for this can be as short as overnight or over a weekend).

To comply with Regulation FD, which governs selective disclosure, an issuer must ensure that the investors it contacts agree to keep the information they receive about the issuer and the proposed offering confidential. The preferred way to do this is by having these investors sign a non-disclosure agreement, but given time constraints, this is being done simply by email confirmation (and in theory express oral confirmation would be sufficient).

Lenders use CDSs to protect against the risk of a borrower defaulting on a loan. In these circumstances, the CDS operates like insurance to cover the lender's loss. By insuring (or hedging) against its potential loss on the loan, the lender has "swapped" its risk of the borrower's non-repayment with someone else in return for an up-front payment.

Hedge funds and other investors use CDSs and other derivatives to enable them to speculate on the market by buying risk in relation to the underlying subject matter of a derivative without having to acquire the underlying subject matter itself. By borrowing to fund the purchase of CDSs and other derivatives, these investors are able to take significant positions based on a relatively small up-front investment.

If a credit event occurs with respect to the reference entity (such as default on a loan), there are two types of settlement the CDS seller could make to the buyer. The buyer could either:

The type of settlement used in any particular transaction is determined by the relevant CDS contract.

The fee (also known as a spread) paid by the CDS buyer to the CDS seller depends on a number of factors, including:

The value of the CDS to the CDS buyer increases as the financial strength of the reference entity decreases.

In a covered swap, the CDS buyer has a relationship with the reference entity and will suffer a loss if the credit event occurs (see diagram Covered CDS).

For example, a borrower borrows from a lender. The lender may pay a CDS seller a fee to buy a CDS on which the reference entity is the borrower and the credit event is that the borrower defaults under the loan.

If the borrower defaults under the loan, the CDS seller will pay the lender the agreed amount. If the borrower does not default under the loan, and repays the lender, the CDS seller has still received its fee but pays the lender nothing.

The difference between a covered swap and a naked swap is that, in a naked swap, the CDS buyer may have no relationship with the reference entity and will not suffer a loss if the credit event occurs (see diagram Naked CDS).

For example, a borrower borrows from a lender. A third party pays a CDS seller a fee to buy a CDS on which the reference entity is the borrower and the credit event is that the borrower defaults under the loan.

If the borrower defaults on the loan, the CDS seller will pay the third party that bought the CDS the agreed amount. Unlike the covered swap, the lender suffering the loss receives nothing under the CDS. If the borrower does not default under the loan, and repays the lender, the CDS seller has still received its fee but pays the third party that bought the CDS nothing.

This kind of CDS is used for speculative trading and essentially exposes the CDS parties to the creditworthiness of the borrower without creating a direct relationship between either party to the CDS and the borrower. A CDS buyer may purchase a number of CDSs with different reference entities. Similarly, there may be a large number of CDS buyers who buy CDSs in the same reference entity.

In an indication of the continued importance of CDSs in the financial markets despite the financial crisis, banks are beginning to use CDS spreads as a basis for pricing loans. Banks have argued that CDS spreads are a more timely and accurate indicator of lending risk in these difficult market conditions than previous indicators which were not reflecting their true cost of funds.

Estimates of the value of the global CDS market vary dramatically. By September, 2008, the SEC estimated the face value of the worldwide CDS market at $58 trillion but in November 2008 the Depository Trust & Clearing Corporation revised this estimate down to $33 trillion. These figures reflect the aggregate face value of all CDSs outstanding (that is, the total if all CDSs were added together). The Depository Trust & Clearing Corporation estimates that if double-counting is eliminated the figure could be $3.2 trillion.

CDSs were believed to spread the risk of defaults, making the financial system more secure and efficient. However, the CDS market was largely unregulated. There were no limits on the number or value of CDSs a financial institution could sell, and no capital requirements on CDS sellers.

As credit events increased, it quickly became clear that CDSs amplified the risks to the financial system and created new risks by increasing the number of parties hurt by one defaulting reference entity. CDSs also created uncertainty in the market. Once a CDS is sold, both the initial buyer and seller can trade their parts of the CDS in the market. This meant that the market had no information on who owned which CDSs or who had what credit exposure to whom. Dramatic fluctuations in CDS prices added to the uncertainty and created a sense of panic in the market.

Exposure to CDS losses was a key factor behind the government interventions in Bear Stearns and AIG. Both AIG and Bear Stearns were large CDS sellers. The government was very concerned about the effect on the various CDS buyers who bought CDSs from them if AIG and Bear Stearns could not meet their obligations on the CDSs. Particularly given the high levels of leverage among CDS buyers, a CDS seller's inability to pay on its swaps can have catastrophic ripple effects. CDS buyers reportedly lost hundreds of millions of dollars when Lehman Brothers, also a CDS seller, collapsed and they were forced to buy replacement CDSs with other CDS sellers.

In addition, there was no public record of how many CDSs had been sold that had Bear Stearns and AIG themselves as the reference entities. Uncertainty about possible repercussions for the rest of the industry led the government to step in.

The two key concerns about the CDS market to emerge from the financial crisis are lack of informational transparency and counterparty risk. Some measures have already been introduced to try to address these concerns and more regulation is expected.

The Financial Accounting Standards Board is requiring CDS sellers to disclose more information on their CDS contracts in their financial statements.

SEC Chairman Cox has requested Congress to grant the SEC jurisdiction to regulate CDSs. The definition of "security" under federal securities law excludes CDSs. The SEC can only enforce anti-fraud laws with respect to CDSs, such as those prohibiting insider trading.

On November 14, 2008, the President's Working Group (PWG) on Financial Markets announced a series of initiatives to strengthen oversight and transparency in the OTC derivatives market, including the establishment of central counterparties (HP-1272: PWG Announces Initiatives to Strengthen OTC Derivatives Oversight and Infrastructure).

The PWG believes that a well-regulated and prudently managed CDS central counterparty can provide immediate benefits to the market by reducing the systemic risk associated with counterparty credit exposures. Central clearing would have reduced the damage caused by Lehman Brothers' collapse by around two-thirds, according to a report by Moody's. It can also help facilitate greater market transparency and be a catalyst for a more competitive trading environment that includes exchange trading of CDS.

The use of a central counterparty also means that post-default there is a standardised and transparent procedure for close-out valuation methodology and terminating and settling contracts. Without a central counterparty there are likely to be a variety of close-out approaches, depending on the terms of the particular contract even if that contract is based on an industry standard form contract. The International Swaps and Derivatives Association (ISDA) (the global trade association representing participants in the privately negotiated derivatives industry) has published a number of protocols for dealing with the settlement of CDSs.

Also on November 14, 2008, the Federal Reserve, the SEC and the Commodity Futures Trading Commission announced the signing of a memorandum of understanding to facilitate the regulatory approval process and to promote more consistent regulatory oversight of CDSs (see Legal Update, CFTC, Fed and SEC Sign MOU Dealing with Central Counterparties for Credit Default Swaps).

In response to the announcement, on November 20, 2008, the New York State Department of Insurance announced that it will delay indefinitely its application of the New York Insurance Law to CDS under guidelines published on September 22, 2008 (First Supplement to Circular Letter No. 19 (2008) and Circular Letter No. 19 (2008): "Best practices" for financial guaranty insurers).

The Depository Trust & Clearing Corporation has begun publishing weekly details of the top 1000 CDSs in an effort to bring more transparency to the CDS market. Large reference entities include countries like Turkey and Italy and financial institutions like GMAC, the financial services company.

Large financial institutions have been moving towards using an online platform to trade certain CDSs. On December 22, 2008, a European venture was announced that provided for the first exchange to offer clearing of CDS contracts in Europe (see Legal Update, First Central Clearinghouse for Credit Default Swaps Begins Operations).

Separately, New York State and federal prosecutors are investigating the manipulation of the CDS market to benefit certain players in the stock market. In theory, if CDS buyers deliberately acted to drive up the fees on CDSs on a financial institution's debt, the cost of insuring that institution's debt would rise. This may make investors worried something is wrong at the institution and may cause the institution's share price to drop. Such manipulation would benefit people who sold short shares in that institution.