CREDIT DEFAULT SWAPS STILL BEING TRADED

THE ROCHE RECORD

by Frank Roche

June 12, 2011

CREDIT DEFAULT SWAPS STILL BEING TRADED


The Credit Default Swap (CDS): an insurance product to protect an investor in corporate or government bonds from default by the issuer of the bonds.  Buyers of CDS get the protection, and the seller of the swap takes on the risk of the bonds defaulting.  As the price goes up, insurance is getting more expensive and the implication is the issuer of the bond is increasingly likely to default on their interest or principle payments.

Introduced to the financial markets by AIG, the CDS is a product of financial engineering which blossomed in the 1990’s as a way for financial services companies to create new “trading” products to increase revenue from the both the selling of the product, and then the speculative gains brought from daily trading of the new product.  The CDS has become a toxic product for the financial markets.  Sadly, little attention was paid to the CDS market in the Dodd-Frank financial reform bill, and daily trading volume is back on the rise with nearly $16 trillion worth of CDS’s, and over 2 million contracts traded in the week ending 6/3/2011.  

The $16 trillion is a notional amount.  Notional amounts are the face values that help determine the profit or loss of an investment, interest payments and the like.  The notional amounts never trade hands, only the amounts gained or lost between the purchase and the sale of a financial product.  In a rational world notional amounts are meaningless, until or unless the price of the product goes to zero.  The larger the notional amount the greater return on the investment for every point gained.  If you buy 20,000 shares of Google at $500 for $10 million, and shortly after sell the 20,000 shares at $510, you’ve made $200,000 before brokerage and taxes.  If you do the same trade only this time with $1 million, 2000 shares, you’ll only make $20,000.  The larger the notional amount the greater the reward and the greater the risk.

Hedging (reducing) risk is an important part of investment management, and there is more than one way to hedge yourself in the financial world.  The CDS was created as a hedging instrument.  However, by now a good deal of moral hazard has crept into the CDS market.  Today, over 75% of all daily volume in the CDS market is dealer to dealer.  This means speculative trading between major financial market participants (investment banks, hedge funds, sovereign funds) who have no concern or connection to the underlying bonds for which the CDS is to protect investors.  It is now just another investment product to make money for a trading desk.  Often times, the notional amount of the outstanding CDS for a particular company or country is greater than the total amount of outstanding debt that is being insured.

The CDS market was at the center of the financial collapse in 2009.  Traders with no interest or connection to the underlying asset, tasked with making a minimum amount of money to earn their salary, each incentivized by higher levels of compensation for every dollar they make above that minimum, wrecked havoc for one financial services company after another.  Something not dissimilar is occurring with sovereign debt in Europe now.

The CDS product should be taken off the market.  Speculative trading in the product should be stopped, and until all positions can be unwound, remaining CDS trading should be done on one exchange.  The CDS has nothing to do with the efficient allocation of resources, the raising of capital for productive means, or the health of the banking sector.

We can do without the CDS market thank you.

3:35 pm edt Comments

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