Credit Default Swaps: Why I've Changed Sides

Time for a little honest disclaimer. So, I've been pounding away at the credit default swap market for some time, saying all sorts of nasty things about it - many of which have come to pass. I'm switching camps now. And putting my money where my mouth is.

Why am I now sleeping with the enemy? Because unlike last year, credit default swaps are going to be regulated, and traded with transparency through one or more clearing houses. For that reason, the chance of an implosion (the likes of which basically took out AIG (AIG), and nearly brought down the entire capital markets last year) is likely to be reduced going forward. So too is the prospect of market manipulation - transparency is anathema to manipulative traders.

Credit default swaps offer a crucial adjunct to the credit markets generally, fostering stability and allowing the market, rather than a bunch of idiots at some rating agency, to establish the relative creditworthiness of borrowers. I'm all for credit default swaps - as long as you give me some transparency and oversight.

How am I implementing my changed view? I am investing in the Chicago Mercantile Exchange (CME Group) (CME). This is one of the places where the credit default swaps market. will reside, going forward. And this is a big marketplace - with notional principal in the tens of trillions of dollars range. A trading platform for credit default swaps certainly has an enormous potential to benefit those who invest in such a trading platform. And the credit default swap market is likely to grow because now as a consequence of transparency, oversight, greater liquidity, and a reduction in counterparty risk thanks to the clearing function CME Group (and in time, others) offer. This will benefit CME Group directly, regardless of the direction in price of these instruments.

I've change my view of the credit default swap market because the structure of this market has changed, rendering the core assumptions of my previous argument obsolete and my conclusions innacurate.

Disclaimer: the author owns shares in CME group.

Comments

[PastTense:]

I think you are putting too much faith in regulation.

For example suppose you have a regulated banking industry. How would it be possible for such an industry to lose such massive amounts of money as to put the whole financial system at risk?

Suppose you have a regulated securities industry. How would it be possible for someone to run a 50 billion dollar Ponzi scheme?

Yet both of these happened.

Jun 02 03:13 PM

[Heaven, Hel...:]

While systemic risk will be reduced -- which is a very good thing -- I am not sure that the CDS market will grow. The very aspect that reduces this risk, namely margin requirements in the form of initial and variation margin, will increase the cost of participation. Also, the tailoring of transactions to meet individual needs will be eliminated to achieve the standardization necessary to promote liquidity. Finally, there is some proposed regulation to limit the universe of buyers of protection to those who hold cash positions in the underlying reference obligations. Taken together, these factors and in particular the last one would result in shrinkage of the market.

Jun 02 03:23 PM

[DannyBoy29:]

CDS' are a useful instrument but as long as you can trade them without holding the underlying debt I still think there are issues. What is to stop me from buying up say $1B in debt of company XYZ and then buying $2B in protectiong in the CDS market. I then do everything in my power to force the company into Ch 11 and collect the $2B in credit default swaps.

Jun 02 03:42 PM

[levin70:]

DannyBoy

The argument is one between the life insurance model vs liquidity. In the life insurance model, you cannot take out an insurable interest against a third party - for obvious reasons (ie you have a real interest in seing the person die, which is bad mkay). This must be weighed against the positive of allowing all to trade - liquidity. If we restrict the contracts only to those with direct interest, the lack of liquidity will (some suggest not, but I disagree) lead to imperfect functioning of the swaps market and thus a failure of the price information we would be receiving from the market.

Kind Regards

Jun 02 05:26 PM

[Donald Ingram:]

Traded with transparency and regulations through a financial clearing house? Wow! Some how - don't quite believe it.
Brings to mind, the cheque is in the mail, Would I lie to you?
Too much liquidity connected with these dubious financial instruments, that are so convoluted in their complexity, as to render them to the realm of the 'Gorgon Knot'!
Lets not forget it was, and is, these very instruments that were, and are, instrumental in twisting the global credit market in knots of the Gorgon variety! Profit is good. Morality of choice in how this profit is gathered, is as important. These odorous contracts 'smack' of something that just doesn't sit right with me. To each their own.

Jun 02 09:07 PM

[Jasper M:]

Regulatory bodies are routinely captured by the very entities they are set to watch. The only good news it, this Usually takes awhile, as cyclical employment 'currents' develop between the watchers and the watched.
In the current environment, however, I fear the corrupt examples available may speed up our 'mean time to failure' on this matter.

This effect is strongest with the largest participants (as they tend to offer the most employment prospects for future ex-regulators), so keep an eye on the what exchanges end up dominating the new public exchanges for these contracts.

Mr. Ingram,
It's "GorDIAn knot". After a king of Phrygia.

Jun 02 09:52 PM

[Alex Trias:]

That's a very, very good point - I had not considered it from that angle. Thank you for your comment.


On Jun 02 03:23 PM Heaven, Hell or Hoboken wrote:

> While systemic risk will be reduced -- which is a very good thing
> -- I am not sure that the CDS market will grow. The very aspect that
> reduces this risk, namely margin requirements in the form of initial
> and variation margin, will increase the cost of participation. Also,
> the tailoring of transactions to meet individual needs will be eliminated
> to achieve the standardization necessary to promote liquidity. Finally,
> there is some proposed regulation to limit the universe of buyers
> of protection to those who hold cash positions in the underlying
> reference obligations. Taken together, these factors and in particular
> the last one would result in shrinkage of the market.

Jun 02 10:03 PM

[john s. gordon:]

the gordian knot was located in the town of gordium in anatolia, and was cut by alexander.

jasper -

as the romans used to say, 'quis custodiet ipsos custodies'.
> jack

Jun 03 08:48 AM

[henarl:]

As to the idiocy of the rating agencies, the real idiots are those who accept the validity of their ratings. The agencies are simply greedy and corrupt. not stupid.

Jun 03 11:29 AM

[john s. gordon:]

it is true, the rating agencies are corrupted by the big fat fees.
> jack

Jun 03 01:06 PM