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Those who argue in favor of “naked CDS” (credit default swaps) say it will increase the liquidity of the market. This argument is valid. In a sense, naked CDS is like short selling. Short sales allow those who believe a security is to fall in price “sell” it even though they may not own it. Permitting short sales is widely believed to allow more efficient price discovery — so that prices will more quickly adjust to their appropriate levels that reflect a more informed market.

However, there is a strong case against it. The reason is that those who buy “protection” only have to pay the premium for the protection, but those who sell the protection (i.e., who issue the CDS) must be sufficiently well capitalized in order to underwrite. Otherwise, should a credit default occur, the issuer will not be able to meet his obligations, and a repeat of the AIG bailout could become necessary.

When a bond issuer is seen to be in trouble, many will be attracted to buy the CDS (seek protection), and as the premiums for underwriting increases presumably this will attract suppliers. But the financial market is under stress, the number of well capitalized CDS issuers will be limited. Consequently there is a likelihood of an imbalance that tends to exaggerate the risks of default. When default risk is exaggerated, more investors will be attracted to “seek protection,” while the cost of borrowing on the debt issuers will rise. The vicious circle will make the chances of a default higher.

On the other hand, if only those who have risk exposure can buy CDS, there is a limit to the amount of protection that will be needed. The problem of imbalance will be less likely. The chances for a vicious circle forming will also be smaller.

Just a while ago the European parliament and member states agreed to curb naked CDS on sovereign bonds. Under the terms of the deal, investors with financial contracts or a portfolio of assets that are judged to be “correlated” to the value of the sovereign debt are considered to be in genuine need of protection and will still be permitted to purchase the credit insurance.

I see this as a healthy development, potentially contributing to more stability in financial markets.

Source: Why I Am Against Naked Credit Default Swaps