by Don Alexander, MBA
Associate, RSD Solutions Inc.
Richard Portes, in a recent VOXEU communique (April 30th), asks this question about the use of Credit Default Swaps (CDSs). In particular, the use of naked CDSs may actually increase rather than decrease systemic risk.
CDSs are derivatives – financial instruments sold over-the-counter (OTC) that transfer only credit risk (corporate or sovereign bonds) to a third party. The purpose of the CDS contract is to provide a form of insurance for an asset held by investors against default losses. These contracts offer payment on default of a financial instrument, even if the buyer of the contract does not own the asset – a “naked” position. This has evolved from the original use of the CDS contract that provided insurance against unexpected losses due to default by a corporate or sovereign entity.
The CDS buyer who desires this protection pays a premium of the asset’s nominal value, in basis points, to a counterparty or protection seller expressed as a spread. European politicians blamed the CDS market for destabilizing Greece. As a result, a new EU regulation was implemented that restricts the use of “naked” CDS positions on sovereign debt.
The gross notional value of these contracts stood at US$15 trillion during the third quarter of 2011, with the majority held on corporate debt. Portes notes the CDS market is a useful innovation when it can provide efficient isolation of credit risk, and is not dominated by naked speculative CDSs positions that are not being used for hedging purposes.
CDS contracts can provide a useful function for price discovery and hedging positions. However, he notes that early research on CDS markets were done with limited data and produced mixed results on how the market functioned.
Portes notes that price deviations can exist in the short-run as CDSs adjust more quickly to news than the cash market. He notes that the derivative CDS market usually moves ahead of the bond market in price discovery, both before and during the financial crisis. In addition, he noted that deviations from a long-run equilibrium could persist between market prices than would normally be anticipated.
Like most financial innovations in recent years, naked CDSs are said to be beneficial in a move toward more complete markets. However, a key lesson from the financial crisis is that innovations can be dysfunctional and dangerous. In this case, naked CDS positions, however, may increase systemic risk. Perhaps the lesson is that by making instruments more complex, we can increase risk and need to limit their use until we have a better understanding of how this market functions.
For more on this follow the link: www.voxeu.org/index.php?q=node/7922
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