Credit Default Sharing: New Islamic Financial Instruments for Hedging Default Risk

The central cause of all recent financial crises (including the Asian financial crisis, the European sovereign-debt crisis and the subprime mortgage crisis) was the debt crisis. The primary objective of this study is to examine the principles of risk-sharing promoted by Islamic finance as a possible reform of or complement to the current financial system. The secondary objective of this paper is to explain how and why the famous credit default swap (CDS) markets expanded and why they contributed to the recent financial crisis. In addition, we propose a new financial instrument to hedge default risk (credit default sharing) based on the principles of risk-sharing and Islamic insurance “Takaful” (sharing responsibility and mutual cooperation) as a substitute for CDS. We explain that “credit default sharing” can reduce counterparty risk, improve banks’ monitoring incentives, reduce systemic risk and contagion in financial systems and eliminate “empty creditors.” © Author