Defenders and Demonizers of Credit Default Swaps, by Rajiv Sethi: The recent difficulties faced by Greece (and some other eurozone states) in rolling over their national debt has let some to blame hedge fund involvement in the market for credit default swaps. These contracts can be used to insure bondholders against the risk of default, but when purchased naked (without holding the underlying bonds), they can serve as highly leveraged speculative bets on a rise in the cost of borrowing faced by the sovereign states.
A cogent case for prohibiting the use of credit default swaps to make directional bets has been made recently by Wolfgang Münchau... Felix Salmon objects... Sam Jones also rises in defense of naked CDS contracts...
So the argument here is that while hedge funds may have raised the cost of borrowing for Greece in 2008-09, their current actions are making borrowing easier and less costly.
Leaving aside the question of whether naked CDS trading has been good or bad for Greece, it is worth asking whether there exist mechanisms through which such contracts can ever have destabilizing effects. I believe that they can, for reasons that Salmon and Jones would do well to consider.
Any entity (private or public) that faces a maturity mismatch between its expected revenues and debt obligations anticipates having to to roll over its debt periodically. Such an entity could be solvent (in the sense that the present value of its revenue stream exceeds that of its liabilities) and yet face a run on its liquid assets if investors are sufficiently pessimistic about its ability to refinance its debt. More importantly, it may face a present value reversal if the rate of interest that it must pay to borrow rises too much. In this case expectations of default can become self-fulfilling.
This is the central insight in Diamond and Dybvig's classic paper on bank runs, and is a key rationale for deposit insurance. William Dudley highlighted the importance of such effects in a speech last November:
If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.
Dudley is speaking here of financial firms, but his arguments hold also for governments that do not have the capacity to issue fiat money. This is the case for state and local governments in the US, as well as individual countries in the eurozone. In either case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic.
What does this have to do with naked credit default swaps? As John Geanakoplos notes in his paper on The Leverage Cycle, such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation.
Whether or not these considerations are relevant in accounting for the troubles faced by Greece is an empirical question. But it does seem to be within the realm of possibility. At least the Chairman of the Federal Reserve appears to think so:
Addressing concerns that financial firms have been engaging in trades to bet on a Greek default, Bernanke said that "using these instruments in a way that intentionally destabilizes a company or a country is counterproductive, and I'm sure the SEC will be looking into that."
Felix Salmon hopes that Bernanke "was just being polite to his Congressional overlords, rather than buying in to this theory." I hope, instead, that he is taking the theory seriously.
---
Update (3/7). Felix Salmon has another post dismantling a New York Times report on the issue. The Times is an easy target, and it is true that their reporting has been riddled with errors and inconsistencies, including a bizarre failure to distinguish between the financial market effects of selling credit default swaps without adequate capital reserves (as AIG did), and the consequences of large scale naked CDS purchases (as hedge funds are alleged to have made).
But what I would like to see from Salmon is a clear distinction between the use of CDS contracts for hedging (which even Münchau would probably agree has beneficial effects on the ease and cost of borrowing) and their use for speculation (which need not). The Sam Jones post does this, and makes clear that if current hedge fund activity is holding down CDS spreads, then prior activity must have had the opposite effect. One may then ask whether Greece (and its fellow PIGS) would be in such a precarious position without this prior activity: this is an empirical question that has yet to be convincingly answered.

Posted by Mark Thoma on Sunday, March 7, 2010 at 02:52 PM in Economics, Financial System Save to del.icio.us Tweet This Permalink Comments (37)

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Anonymous said...
Greece is perfectly able to bet against its own default.

Reply Mar 07, 2010 at 03:15 PM

Bruce Wilder said in reply to Anonymous...
Maybe, they should secretly bet on their own default, and then make it so, like a prize fighter throwing a fight.

There was definitely an element of that, when Goldman Sachs "insured" securities of its own creation with AIG.

Reply Mar 07, 2010 at 03:26 PM

Goldilocksisableachblond said in reply to Bruce Wilder...
"Maybe, they should secretly bet on their own default, and then make it so, like a prize fighter throwing a fight."

I'd love to see that happen , but somehow I think the people of Greece would get screwed anyway.

Better might be use even more gov't debt to bet - BIG - on their own default , then default on payment of both the debt AND the bet. ( aka The Goldman Sting )

Reply Mar 07, 2010 at 03:56 PM

Leigh Caldwell said...
Even if it were desirable to ban naked CDSs, would it even be possible? Without eliminating the whole CDS market that is:

http://www.knowingandmaking.com/2010/03/indecent-exposure-putting-clothes-on.html

Reply Mar 07, 2010 at 03:33 PM

paine said in reply to Leigh Caldwell...
leigh anne my friend read bruce w below

he outlines just why you might not want to allow nakedness

"Goldman Sachs synthesizing securities that they knew carried a lot of risk, and then buying CDS from AIG, comes to mind"
get it ???

produce stealth shit
sell the stealth shit
buy insurance
not a hedge but a hammer

to be sober here
your post at hoime site toys with cvs
well cvs can be modularized too eh ??

and don't be so easily trumped by liquidity fears
or the improvement in price signals thhat increased liquidity might yield

its all largely taboo gaming by insiders

bruce is correct to suggest amateur sleuths
approach these markets with caution

i don't pretend to get the game here
but it really isn't insurance
if it were it would be a steady tax on risk
somewhat proportional to that risk
not a bonus play
free to drive leads to congestion eh ??

Reply Mar 07, 2010 at 05:12 PM

Uncle Billy Cunctator said...
Oh how the mobsters love insurance scams.

Reply Mar 07, 2010 at 03:44 PM

save_the_rustbelt said...
Try to buy insurance on a car you don't own, the agents will look at you like you are seriously crazy.

Reply Mar 07, 2010 at 03:54 PM

paine said in reply to save_the_rustbelt...
rusty
the whole life market can be arbitraged precisely by assuming life policies the holder drops
for the tdrastically undervalued
cash on surrender
right ??
forcing down premia to payout ratios

myopic moral hazard strictures
limits the keen possiblities of default insurance
i like to imagine a system where compulsory life insurance is part of the credit system
term life here not whole life of course
once a debt is paid off the insurance expires
we need such a system i think
where no one pays anything back if they don't want to
but they have to pay the insurance like they have to pay a tax
and it needs to be whole people pooled of course
though rated as now person by person

Reply Mar 07, 2010 at 05:47 PM

RW said...
Insurance? Therein lies the rub: The creators of CDS's apparently spent millions on packs of lawyers who successfully argued that CDS's were not insurance and, eo ipso, not subject to the relevant controls, local laws, etc. AFAIK this remains the case.

Reply Mar 07, 2010 at 04:05 PM

paine said in reply to RW...
well it's not insurance its a bet
but then insurance is a bet too eh
risk based systems are all bet systems in the small but zero sum systems in the large
which means winners earn less then the whole take

but we need to have the casino empowered
to print money to make this really rocket speed stuff no ??

ie uncle sam as ultimo compulsory re insurer

the unitary credit dome chapter two

difference its still a bet
if it's a rigged race
it's just not insurance its crime

Reply Mar 07, 2010 at 05:52 PM

Bruce Wilder said...
Exchanging pieties about "good" hedging and "bad" speculation is not particularly helpful as economic analysis. Proving your bona fides, by ritualistically condemning "naked" CDS bets, does not prove that you have the slightest idea what you are talking about, let alone does it constitute a useful economic analysis of the system effects.

There are some fundamental issues, here. I can see three peeking through the fog of esoteric financial jargon.

Mark Twain explained portfolio theory this way: either you should not put all your eggs in one basket, OR you should put all your eggs in one basket and then watch that basket.

Some actors in the economy are controlling processes, reducing error. You really do not want someone charged with actively guarding a basket of financial eggs to be able to insure against their loss -- you can call that moral hazard or whatever you like, but the bottom line is that insurance is not always a net gain in efficiency. Spreading the loss widely is not all to the good; sometimes, focusing the loss on folks, who have the power to reduce the loss, is a gain to society.

I would think that would be the point behind not allowing "naked" CDS, but it seems to me that the "naked" thing does cover all the cases, where, maybe, CDS is a bad, bad idea.

Leverage, in an ordinary business, is a way of achieving a balance between "insurance" to reduce the costs and expense of volatility in business expenses and outcomes, and focusing incentives on management, put in a position to control the production processes in a way to that minimizes the losses due to waste and error and so on. The contractual obligations that establish priority are what focuses the incentives of risk. We don't want to be undoing those contractual obligations, with esoteric financial engineering.

Goldman Sachs synthesizing securities that they knew carried a lot of risk, and then buying CDS from AIG, comes to mind. For economists, putting the story this way tempts them to shout "asymmetric information", and I suppose that is an important part of the story. Adverse selection and moral hazard, at a certain level of abstraction, are exactly the same thing.

But, I would not want to let responsibility for control leak out of the story. I know I hammer this point all the time, but it is important: there are important economies from technical control of production processes, even in banking. Economics, focused on incentives and allocative efficiency exclusively, tends to give this aspect of the situation short shrift, but it is often critically important. Underwriting mortgages and underwriting mortgage-backed securities were both processes that deteriorated markedly in the run-up to the recent crisis. Someone is supposed to manage those processes -- manage them in a technical sense, to prevent bad debt from being created, by due diligence, winnowing out the fraudsters and so on. The incentive for doing that job can not be "insured" away, without doing damage. And, it seems as if it was "insured" away, and tremendous damage was done.

But, if we are going to shout, "asymmetric information", then let's tie CDS to financial reporting, because that's what CDS is so often about. If you see CDS as extreme leverage, congratulations. Gold star on your forehead. Now, how are the contingent liabilities to be reported, if they are reported at all? What are the words that will be used in the financial statement, next to the nice round numbers, which will allow either managers, or stockholders, or government regulators or bondholders, to know what is going on.

How is a Graham & Dodd investor supposed to make heads or tails of what a CDS is doing for a bank or an insurance company or an ordinary industrial company, if there be such, in our brave new world. I don't mean this to be just a luddite rant against financial innovation, but I do question whether some of these esoteric instruments are not just opportunities for perpetuating sophisticated frauds.

Finally, I want to mention the Minsky effect. Economists love their stasis, and the idealization of competitive markets, arriving at balanced perfection. But, Minsky saw financial markets, correctly I think, as having a socially predatory tendency toward cycles of boom and bust. Acceleration thru leverage from good hedge finance to bad speculative finance was his central story. CDS looks like financial acceleration on steroids. YMMV, but what social benefit would we lose, if we banned CDS entirely? Really.

Reply Mar 07, 2010 at 04:17 PM

paine said in reply to Bruce Wilder...
"sometimes, focusing the loss on folks, who have the power to reduce the loss, is a gain to society"
indeed they ought to be subject to kill shots
even if their "firms "are not
however insurance for the firms outside stake holders is another matter

to intensify the personal stakes
the players ie agents need to be incentivized correctly

i suspect insurers are the ones in this case to look into this before rating the issue

and of course their insiders need to be correctly incentivized also

infinite regress here ??
lets hope so that feed back screech ought to be audible miles away from the office tower where these groups conspire
but alas...
so we need to make the conspirators screech that loud when their caught

the stock holders of insurers need investigative guys
like george peppard
only in this case with 00 status

Reply Mar 07, 2010 at 05:19 PM

paine said in reply to Bruce Wilder...
" it seems as if it was "insured" away, and tremendous damage was done."
no the aids like nature of the scam here
the antibodies were subborned first
ie aig investigators moody raters etc
this was a daisy chain bruce eh ???

a scam from alpha to omega

Reply Mar 07, 2010 at 05:27 PM

paine said in reply to Bruce Wilder...
"what social benefit would we lose, if we banned CDS entirely? Really."
none
because partially socialized risk is inefficiently socialized risk
that profound reality the bigger the pool the better for risk
only fails as all pooling fails
if the risk is really a scam in sheeps clothing

Reply Mar 07, 2010 at 05:30 PM

Gump_does_Irony said...
it is basically a tweedledum and tweedledee debate ...!

What exactly does "... the use of CDS contracts for hedging ... has beneficial effects ..." mean? The only person that would need to hedge is somebody who has credit exposure to the issuer, i.e., one that owns a bond. If the credit exposure becomes undesirable, the straightforward solution is to sell the bond; what exactly would the point be in buying CDS protection instead? Usually, the answer is that there is less liquidity in the cash bond market to sell the bond whereas it may be easier to find someone (a hedge fund) willing to take the credit exposure by selling a CDS contract on the bond. However, the reason why that hedge fund is not willing to purchase the cash bond outright but is willing to sell the CDS (both are effectively the same credit risk and return) has to do with the need to come up with the cash (and the capital) in the case the cash bond purchase. A CDS contract allows the hedge fund to own the credit without putting up the capital to do so; if said hedge fund were to be forced to own the cash bond, they have to either have the capital (or explicitly borrow against their capital, i.e., leverage) to do it. On the other hand, a CDS contract opens the door to the hedge fund to obtain implicit and opaque leverage that is magnified severalfold because all the hedge fund needs to do to own a CDS contract is the ability to fund margins, i.e., daily changes in the value of the CDS contract, which are typically a small fraction of the price of the cash bond.

If opaque and excessive leverage in the hands of hedge funds is how the extra liquidity becomes available to the original cash bond owner, how that benefits said bond owner (and in turn the issuer of the cash bond) is the unanswered question. It is fairly easy to see how this extra liquidity is a contrived situation and is inherently unstable.

Now, looking at this from the CDS buyer's side, especially if it is a naked CDS purchase, it changes the incentive structure quite dramatically. A natural owner of credit is typically willing to work through a stress situation and restructure the obligation in such a way as to optimize the payoff to both parties. On the other hand, a holder of a CDS insurance contract is not only uninterested in an orderly restructuring, but actually is incented to see the borrower fail so that the insurance policy (in reality a naked bet) can be collected on in full! The more such insurance policies he owns, the greater the incentive to force a failure. CDS contracts make it easy to purchase multiple insurance policies with relatively little capital (and thus for several players in the market to collude on the bet in huge size); the next step in this easy money strategy is to orchestrate a trash-the-credit campaign through gullible and/or compromised financial journalists and bloggers ...

I wonder what the reaction of Felix would be were he to discover that someone other than his mortgage lender is loading up on multiple insurance policies on his home! it should not be too difficult to discern that the incentive structure begins to favor the arsonist pretty soon!!

Reply Mar 07, 2010 at 04:24 PM

Bruce Wilder said...
The Sam Jones story of the "benefits" of a naked CDS in speculation on sovereign Euro debts is exactly the kind of idealistic stasis story economists like, and, also, exactly, the kind of thing Minsky was talking about. Sam Jones makes it sound like smoothing, static goodness: short-sellers giving themselves an incentive to keep a market in decline, liquid. A lovely fairy tale, obscuring an instance of accelerating the cycle, by creating yet another means of fleecing the rubes through boom and bust.

Reply Mar 07, 2010 at 04:43 PM

paine said in reply to Bruce Wilder...
exactly

if you don't see the limits of arbitrage
and all the rest of the dynamic noise and dirt
one can exploit with "perfected" foresight
as evil clark winner
plutonian familiar
peculator
and greek letter mephisto
andy shleifer proved
--irony eh ??--

Reply Mar 07, 2010 at 05:24 PM

paine said in reply to Bruce Wilder...
the risk pool needs to be loke the nordic ocean serpent too big to be lifted out of its water depths
since it surrounds terra firma this avoids
the horror of noah wins only outcomes

Reply Mar 07, 2010 at 05:33 PM

paine said in reply to paine...
loke ??... is look

not some brother of the trickster god

Reply Mar 07, 2010 at 06:06 PM

Goldilocksisableachblond said...
When someone pops up claiming they're the Second Coming , people rightly label them as crackpots , generally speaking. Yet Blankfein and others who defend the usage of such things as naked derivatives , claiming they're doing God's Work , are for some reason taken seriously by many.

Here's another example , on the issue of high frequency trading :

Why policymakers need to take note of high-frequency finance
Richard Olsen
6 March 2010

http://www.voxeu.org/index.php?q=node/4725

His summary :

"High-frequency finance holds out the hope of turning aspects economics and finance into a hard science by the sheer volume of data and its ability to set events into their appropriate context by mapping rare events into a short-term time scale with a near infinity of events, albeit at a shorter-term time scale. Second, the tracking of events on a tick-by-tick basis opens the door to identify underlying flows and develop economic weather maps. Surely that’s not a bad thing?"

...

His goal ?

"In the end, he says, his goal is to make the financial system work better and more safely."

http://alansforexblog.com/2008/02/03/a-day-in-the-life-of-dr-richard-olsen-founder-of-oanda

So , he must be an academic or philanthropist , right? , out to make the financial world safer for us mere mortals. No other motives , right ? Well , let's see :

"Currently, most of my time is dedicated to Olsen Ltd and Olsen Investment Corporation. Olsen Ltd develops quantitative statistical trading models for trading currencies. Olsen Investment Corporation offers managed currency accounts, markets a hedge fund called High Frequency Data Fund and other currency related investment products."

....

He might be right about HFT , for all I know. But if we're going to cast a wary eye on Al Gore because he stands to gain financially on his green tech investments if climate change policies are enacted , shouldn't we take a close look at those who advance financial reform agendas , and how they would stand to gain from adoption of those agendas ?

We need a variety of opinions on these debates , but we also need to know who's really behind those opinions and how they make their money , and then weight those opinions accordingly.

Reply Mar 07, 2010 at 05:03 PM

paine said in reply to Goldilocksisableachblond...
lovely

this high frequency shit
is liquidity fetish a go go

Reply Mar 07, 2010 at 05:34 PM

RueTheDay said...
I have a bigger issue with the very concept of credit insurance.

In any fixed income security, the interest rate is supposed to reflect (among other things) credit risk. In theory, the cost of a credit insurance vehicle (e.g., CDS) should be exactly equal to the risk premium attached to the interest rate in its absence. The fact that credit insurance exists means it’s cheaper than the interest rate risk premium. Unless there is some sort of information asymmetry or economy of scale that a monoline or a CDS protection writer has over THE ENTIRE BOND MARKET, there is no reason for this to be the case. The existence of credit insurance is predicated on the underpricing of risk, furthermore it ENCOURAGES the underpricing of risk.

Reply Mar 07, 2010 at 05:35 PM

paine said in reply to RueTheDay...
no
not that basic a problem
you throw out a baby here not some mutant beast

Reply Mar 07, 2010 at 07:45 PM

paine said...
"High-frequency finance holds out the hope of turning aspects economics and finance into a hard science by the sheer volume of data and its ability to set events into their appropriate context by mapping rare events into a short-term time scale with a near infinity of events, albeit at a shorter-term time scale. Second, the tracking of events on a tick-by-tick basis opens the door to identify underlying flows and develop economic weather maps. Surely that’s not a bad thing?"

this is what my uncle called

bronx sophistry
ie plain old double talk

Reply Mar 07, 2010 at 05:37 PM

paine said...
we need to clear up the diffrence between shorting a security and buying naked insurance on it
i'm too lazy to think this through right now

like the old prussian censorship
i take the restrictive frame
its prohibited if its not permited
in this case under lemma 13
its a no
lemma 13 ??
if its not fully understood
its out

so no nakedness till proven innocent

like patent on a device that the patent office
isn't certain performs as touted
zap
till we are sure

Reply Mar 07, 2010 at 06:02 PM

paine said in reply to paine...
okay a short wins if prices drop
a cds wins only if the security is forced into default

but i want a model to make certain i got the whole wiring diagram here

Reply Mar 07, 2010 at 06:04 PM

paine said in reply to paine...
can you sell your naked cds on a secondary market ??

Reply Mar 07, 2010 at 06:05 PM

Gump_does_Irony said in reply to paine...
Yes; back when the CDS instrument originated, the CDS buyer was required to actually deliver the reference security (the cash bond) to the CDS seller upon the occurrence of a 'credit event' (typically an event signifying a default on the part of the issuer of the security). In exchange, the CDS seller has the obligation to pay par value for the reference security.

Somewhere along the way, the whole thing transmogrified into an arrangement where the requirement to deliver the reference security was abandoned in favor of a net settlement against a privately auctioned value for the reference security. This meant that a CDS buyer no longer had to own (or buy) the cash bond in order to deliver against the CDS contract settlement, but ISDA (a trade body comprised largely of the big banks) would simply hold a private clearing auction of all outstanding CDS contracts ex post after the default happens, thus opening the flood gates for side betting on the reference security.

Reply Mar 07, 2010 at 06:40 PM

Gump_does_Irony said in reply to paine...
A CDS sale is roughly the same as purchasing a cash bond, i.e. seller takes credit exposure and gets paid the credit spread, excepting he doesn't have to put up the principal. It is technically a swap where you simultaneously borrow in the LIBOR market to fund the purchase of a cash bond, and put up the purchased cash bond as collateral on the LIBOR borrowing. So what you are left with is a risk/return profile where you are long a cash bond funded with a LIBOR liability, but with both items off your balance sheet. Of-course, your LIBOR lender will want you to post additional cash (margin) when the value of your cash bond collateral falls in relation to the LIBOR borrowing. Since this margin is the only ongoing obligation of the CDS seller, the CDS instrument allows you to effectively own the equivalent of a lot more cash bonds for a unit of risk capital in contrast to a funded on-balance sheet cash bond holding situation.

Reply Mar 07, 2010 at 06:24 PM

Gump_does_Irony said in reply to paine...
For clarity, a short of a cash bond is on the opposite side of a CDS seller. A CDS seller is taking a long position on the underlying cash security.

Hope this helps.

Reply Mar 07, 2010 at 06:52 PM

paine said in reply to Gump_does_Irony...
gump
i like your clarity

but i need a model that allows me to link to analogues better understood

rajiv uses the bank run model

i don't know if that is adequate or not

Reply Mar 07, 2010 at 07:29 PM

Anonymous said...
Keep interest rates a little higher such that insurance premiums are expensive relative to savings accounts.

Reply Mar 07, 2010 at 06:24 PM

paine said in reply to Anonymous...
the voice of rentiers past speaks from the crypt

Reply Mar 07, 2010 at 07:30 PM

mrrunangun said...
The German, Swiss, and French central banks could sell CDSs against Greek default to Mr. Soros and his friends to support Greece and reduce the interest rates it will have to pay on its bonds. As the Germans and the French are in a position to guarantee the Greeks against a default, they might economically suppress the speculative attack on Greece and the Euro without buying the Greek bonds themselves. This would have to be contingent on Greece putting itself under the authority of the EU for enforcement of the finance reforms of the Greek government.

Reply Mar 07, 2010 at 06:52 PM

paine said in reply to mrrunangun...
to overtly insure the bonds sounds like the solution
and to get premia along the way for it
also sounds bright
in fact only the guys with nthe euro mint behind em
ie the central bank oughta issue these policies
and only to bond holders

Reply Mar 07, 2010 at 07:33 PM

paine said...
i want to add
rajiv
is really aces

for a second tier barnyard piker
he sure out performs
all these giant blow fish
like stiglitz and delong and shiller
we watch swim down river past us
in endless self important succession
here at thoma town

i read rajiv's blog like few others

Reply Mar 07, 2010 at 07:39 PM

Robert Waldmann said...
Sethi's argument can be summarized as follows -- over insurance leads to arson.

Shift the focus a few miles North from Wall Street. You will find burned out buildings. In the 70s there were a huge number of fires in New York. Then the City made sure that there weren't buildings insured for more than their market price. The rate of arson declined sharply.

In general it is not legal for anyone to profit from an event by buying insurance against some event. As far as I know, in all other insurance markets, the equivilant of a naked CDS is forbidden. This general rule was avoided by naming credit default insurance a credit default swap. Naked CDS can make the financial equivalent of arson profitable. Sethi is not the first person to point this out .

http://www.angrybearblog.com/2008/09/financial-arsonists.html
(note the date stamp -- September 2008 -- some time ago).

It is easy to prevent this. There are different kinds of CDS : cash settlement CDS and physical settlement CDS. If you own a physical settlement CDS and the asset in default, then you get the face value of the asset in default. It is legal, but unwise to buy a naked physical settlement CDS. If the nominal value of physical settlement CDSs is greater than the value of the insured instrument outstanding, then, in case of default the physical settlement CDSs are worthless and the underlying asset is worth just as much as it was without default. This has happened. It is not theory it is a known fact.

Cash settlement CDS were invented because existing instruments did not make it possible to gain huge profits when an entity defaulted. If this is considered an undesirable situation, it is trivially easy to avoid it by banning cash settlement CDS. This again is trivially easy just by saying that a cash settlement CDS contract won't be enforced so I can buy something which says someone will pay me a huge amount of money in case of some default, but if that default occurs I can't make him pay me anything. The regulatory problem is trivially easy -- declare *new* cash settlement CDS to be non-contracts of no legal significance.

Now what is the disadvantage of banning cash settlement CDS ?

Reply Mar 08, 2010 at 01:47 AM

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