Now I'm no expert in the mechanics of the CDS market, but it does strike me that almost no one will buy credit protection from a seller they're not completely sure about. It defeats the purpose of buying the protection in the first place: why pay money to protect yourself against a default, if that default would bankrupt your counterparty and leave you with no money anyway?
Which means that in practice, anybody wanting to buy protection is going to buy it from a big broker-dealer, and quite possibly from a special-purpose bankruptcy-remote vehicle set up by that broker-dealer for specifically that purpose.
But what about the broker-dealers themselves? They make a market in this stuff, and therefore should be willing to buy protection from just about anybody. So it's the big CDS broker-dealers, like Deutsche Bank and JP Morgan, which should be most worried about counterparty risk in the CDS market. But they're also the players who are most likely to know what they're doing, and to have elaborate risk controls set up to address exactly this problem.
Many of their counterparties, of course, they don't need to worry about. When a bond fund plays in the CDS market instead of the bond market, or when AIG writes credit protection, the chances of either entity blowing up as a result of paying out on a credit default swap is minimal.
But big bond funds and insurance companies aren't the only writers of protection in the CDS market. There's also hedge funds, who are much more prone to blowing up, and who can use CDS as a source of leverage. Essentially, writing credit protection is free money: you collect your insurance premiums and have to pay out nothing unless and until there's a default.
And broker-dealers are desperate for hedge funds' business, because it's very profitable. So they might well end up with non-negligible counterparty exposure to a fund which turns out to be a big net writer of credit protection.
Still, the broker-dealers are big boys, and I'm not going to get too worried on their behalf. I'm more interested in Smith's conclusion:
If enough financial players are distrusted as counterparties for routine transactions, one would think at a certain point those worries have to infect the CDS market.
If enough financial players are distrusted as counterparties, then there will be fewer counterparties able to write credit protection – in other words, the supply of that protection will go down. When supply goes down, the price goes up, and implied yields in the CDS market could rise. But that's nothing which hasn't happened quite dramatically over the past week or two.
And what would happen to the CDS market if there was a big corporate default and a hedge fund found itself unable to pay out on all the protection it had written? Answer: the broker-dealers who bought the protection from that hedge fund would essentially take over all the rest of its assets. I don't think it would be the end of the world.