A credit default swap (CDS) with a fixed recovery rate that is determined at inception and applied to all credit events is sometimes referred to as a "digital" or "binary" credit default swap. These structures offer both protection-buyers and -sellers several benefits. The valuation process, which is otherwise central to the cash settlement process, is avoided altogether, removing the need to ensure that its provisions are objective and comprehensive. Most importantly, the variability of recovery rates that is often present with cash settled credit default swaps is no longer present. Additionally, concerns surrounding liquidity of distressed or defaulted asset backed securities (ABS) are also mitigated.
Although digital CDS still represents only a fraction of the CDS market, interest is growing rapidly. Nevertheless, there are risks associated with digital credit default swaps that differ from those associated with more conventional CDS. These risks are more likely to occur when soft credit events are present, and may be addressed in a number of ways.