Credit Default Swap (CDS) was regarded as an insurance instrument againstthe default risk of a debt obligation. Buyer receive pay-outs from sellers on acredit event of a particular entity, and in return pay premiums to sellers.

However, unlike insurance, CDS buyers do not have to have an interest in theinsured entity and it is traded in the over the counter (OTC) market.

In 2003, Warren Buffett warned that CDSs are "weapons of mass destruction". His warning unfortunately came true in 2008 that the virtually unregulatedOTC market in CDSs has played a significant role in the credit crisis. Even thefather of CDS - Nobel prize-winning economist Myron Scholes who developedmuch of the pricing structure used in CDS said that OTC CDS were so dangerous that they should be "blown up or burned", and we should startfresh.

Why CDSs are dangerous?