NOT all credit products are created equal. The credit-default swap (CDS) market is going from strength to strength, with outstanding volumes rising from an already staggering $34.4 trillion at the end of 2006 to $62.2 trillion at the end of last year. In contrast, issuance of collateralised-debt obligations (CDOs) has fallen dramatically. It was a paltry $11.7 billion in the first quarter, down from a record $186.5 billion in the same period the year before.

At first blush, this might seem surprising. After all, during the boom years for CDOs, the two products were closely intertwined. Traditional CDOs bundled bonds into portfolios and then split those portfolios into tranches, depending on investors' appetite for risk. Some investors wanted a higher return but were willing to take the first hit from bond defaults; other investors were more concerned about the safety of their capital and were willing to accept a lower return.

The idea was so popular that there were not nearly enough corporate bonds to go round. So managers created so-called “synthetic” CDOs, in which the portfolios consisted of credit-default swaps. In a CDS, one party agrees to insure the other in the event of a bond default, in return for a fee (the equivalent of an insurance premium). So in a synthetic CDO, those who owned the riskiest tranches got more of the premium but lost out when defaults occurred.

There is, in theory, no limit on the amount of default swaps that can be created. So when managers wanted to sell a synthetic CDO, they simply created some more CDSs. Now that the CDO market is in the deep freeze, thanks to all those subprime-related losses, that source of demand has dried up.

But there have been plenty of other buyers. After all, it is only natural that, with the likelihood of bond defaults increasing, more investors should want to buy insurance against such events.

More importantly, however, the CDS has become the product of choice for those investing in credit as an asset class. Five to ten years ago, the corporate-bond market was a lot less active; there was little trading in the bonds themselves, which were often locked up in the portfolios of pension funds and insurance companies.

The invention of the CDS increased the liquidity of the market and, crucially, allowed investors to take a “short” position on bonds. Traditionally, you would buy a corporate bond at, say, 95 cents on the dollar. The best you could hope for was that interest would continued to be paid and that the bond would be repaid at par; at worst, the issuer could default and you could conceivably be left with nothing.

Now investors who believe that credit conditions will deteriorate for a particular company can buy a CDS on the bond, whether or not they own it. The value of such an insurance contract will rise if default becomes more likely. The creation of index contracts on the market allows you to bet whether all corporate bonds (or, indeed, different segments of the market such as investment grade and junk bonds) will rise or fall in value.

As a result, the CDS is such a useful instrument for hedge funds and the trading desks of investment banks that it seems inconceivable it will go away. Just as the future on the S&P 500 index is a key part of the equity market, the CDS is central to non-government debt.

But could it be the Achilles heel of the financial markets? One clear problem is counterparty risk; insurance is worth nothing if the insurer cannot pay up. The involvement of Bear Stearns in the credit-derivatives market was one reason why there was a public interest in the firm's rescue; a default might have caused chaos as other counterparties struggled to calculate their risk exposure.

Another problem could emerge if a sudden surge in defaults was accompanied by a further widening in spreads. The market might become illiquid if those that had in effect sold insurance tried to exit their positions.

Market insiders are confident the CDS sector can stand up to the strain. Ashish Shah of Lehman Brothers says that the CDS market showed itself robust in the face of the Enron and WorldCom defaults in 2001 and 2002, and of other bankruptcies since then.

However, many market participants were equally reassuring about the health of the CDO market in early 2007—and look how that turned out. Independent observers will not be really reassured until the system survives the test of a big, juicy default. Given the weakness of the American economy and the scale of the credit crunch, it probably will not be long before that test comes along.