After the debacle of 2008, commentators still like to assume that CDS and other derivative contracts do not involve counterparty credit risk. (See Greycap’s comment here.) It is astounding that the near collapse of the financial system is not enough to make people realize that the best a CDS can do is transfer your credit risk from the underlying to a counterparty. The only circumstance in which a CDS transaction can eliminate credit risk is if the CDS protection is sold by the issuer of the currency in which it is denominated (or in the impractical scenario that initial margin is the full notional value protected). As far as I know the central banks aren’t in the business of selling protection.
Repeat after me: Every CDS creates counterparty credit risk. A CDS cannot eliminate credit risk. For a given purchaser a CDS may serve to transfer credit risk from a less credit worthy borrower to a more credit worthy counterparty — but it is impossible for a derivative to eliminate credit risk.
I’ll comment on how collateral fails to solve this problem in a future post.