"Ban Naked CDS"

Richard Portes of the London Business School argues we should ban naked credit default swaps:

Ban Naked CDS, by Richard Portes, Eurointelligence: In a credit default swap (CDS), the buyer contracts to pay the seller a regular premium in return for a commitment that the seller will pay out in the event of a default on a specified financial instrument, typically a bond. The market began in the late 1990s as a pure insurance market that permitted bondholders to hedge their credit exposure – an excellent innovation.

But then market participants realized that they could buy and sell ‘protection’ even if the buyer did not hold the underlying bond. This is a ‘naked’ CDS, which offers a way to speculate on the financial health of an issuing corporate or sovereign without risking capital, as short-selling would do. That was so attractive that soon the market was dominated by naked CDS, with a volume an order of magnitude greater than the stock of underlying bonds.

A good side effect of Greece’s troubles is that politicians, regulators and central bankers are finally paying serious attention to this market. For two years, I have been pointing out the destabilizing effects of naked CDS in the financial crisis and the dangers in the use of these instruments as a speculative device. Only now is this taken seriously. ...

Let’s look at naked CDS seriously, ignoring Greece. We start with the justifications. [goes through and argues against the standard justifications for CDs] ...

The most obvious argument against naked CDS is the moral hazard arising when it is possible to insure without an ‘insurable interest’ – as in taking out life insurance on someone else’s life...

The most important argument is related to this moral hazard. Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. ...

The mechanism of CDS is like that of reinsurance. The fees are received up front, the risks are long-term, with fat tails. There are chains of risk transfer – a CDS seller will then hedge its position by buying CDS. So the net is much less than the gross, but the chain is based on the view that each party can and will make good on its contract. If there is a failure, the rest of the chain is exposed, and fears of counterparty risk can cause a drying up of liquidity. The long chains may create large and obscure concentration risks as well as volatility, since uncertainty about any firm echoes through the system.

Naked CDS increase leverage to the default of the reference entity. They can thereby substantially increase the losses that come from defaults. And the leverage comes at low cost – nothing equivalent to capital requirements, no reserve requirement of the kind insurers must satisfy,

Banning naked CDS will require common action in the US and the EU, but the political environment is right. We should not lose this opportunity