Understanding Credit Default Swaps in Fixed Income

In the landscape of fixed income securities, credit derivatives serve as essential instruments for managing credit risk. A prominent type of credit derivative is the credit default swap (CDS), which allows an investor to 'buy protection' against the default of a borrower. Assume a CDS trade where an investor pays a premium to the protection seller in exchange for compensation in case of default.

If the underlying reference entity experiences a credit event, the protection seller must deliver the notional amount of the swap to the protection buyer, while the buyer typically delivers the defaulted asset or its equivalent value. It's crucial to understand the implications of counterparty risk, the role of collateral, and the potential for systemic risk in the use of CDS.

Given this background, which of the following statements accurately reflects the mechanics and risks associated with credit default swaps?