There has been much debate in recent days regarding whether the market for Credit Default Swaps (CDS) should be more tightly regulated. Let’s take a look at the nature of credit default swaps and whether arguments for tighter regulation have merit.
What are “Naked” Credit Default Swaps?
CDS are swap contracts in which the buyer makes a series of payments to the seller in return for protection intended to hedge against a default of a credit instrument such as a bond. When such instruments are used as a hedge, the buyer of the CDS owns the underlying security and is attempting to protect against the default of that security. Such an investor is essentially purchasing an insurance contract except the transaction is not structured as traditional insurance but takes the form of a derivative that is usually a tradable security.
It is legal for someone with no underlying exposure to the credit instrument to purchase CDS protecting against the default of that instrument. This is known as a “naked” position in the CDS. Such positions are taken by those who are making a bet either on a default, in which case the CDS would pay off, or increased perceptions of a default in which case the CDS would appreciate and could be sold to someone else seeking protection against default.
The Case for Stricter Regulation
George Soros recently wrote an op-ed piece for the Wall Street Journal making a strong case in favor of stricter regulations that would ban naked positions in CDS. Soros believes that the use of CDS in the recent past facilitated bear raids in which the shorting of stocks and buying of CDS against defaults of financial institutions combined to result in a self fulfilling prophesy. Since a decline in the share and bond prices of financial institutions can result in increased financing costs, such bear raids can be “self validating” events in which the raid itself results in the eventual destruction of the financial institution. Soros refers to the manner in which the distortion of prices in markets may affect the underlying reality that the prices are supposed to reflect as “reflexivity” and he wrote extensively on the subject in The Alchemy of Finance.
Soros goes on to explain how CDS can facilitate going short on bonds except without the traditional downside of taking a short position:
The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one’s risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.
Soros then explains how the nature of buying a CDS limits risk while providing the opportunity for almost unlimited profit potential while contrasting this with the position of the seller of the CDS who has a limited profit potential but nearly unlimited downside risk:
Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.
Since CDS are generally tradable and can be sold anytime, no actual default is required to realize profits. Instead, they can be profitable even if there is only a perception of a higher risk of default for the underlying security:
People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.
Soros clearly believes that the combination of naked positions in CDS and the unlimited shorting of stocks due to the elimination of the uptick rule combined to cause the demise of several financial firms over the past year:
Taking these three considerations together, it’s clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination.
Soros appears to make a strong case in favor of banning naked positions in CDS as well as bringing back the uptick rule which was eliminated in 2007. However, there are others who disagree with the need for tighter regulation of CDS.
The Case for Allowing Naked CDS Positions
In testimony before the House Financial Services Committee on Thursday, March 26, Treasury Secretary Geithner made the following statement regarding naked CDS positions:
I know there are strong opinions on this issue, so I say this with some trepidation. My own sense is that banning naked (CDS) volumes is not necessary and wouldn’t help fundamentally in this case. It’s too hard to hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome. If we could find a way to separate those two types of transactions from each other, we would have done that a long time ago across a whole range of financial innovations, but it is terribly hard to do. But we will listen carefully to any ideas in this area and understand why people feel so strongly about this.
Our view is that the absolutely essential thing is that there is more capital held against these positions so we never again face the situation where those types of judgments could imperil the system.
The position Secretary Geithner is taking does not really refute any of the points made by George Soros. Instead, he is saying that it would be next to impossible to differentiate between naked CDS positions and positions intended to hedge underlying exposures. Rather than banning naked CDS positions, Geithner is in favor of increasing capital requirements for financial institutions writing CDS such that the kind of systemic risk that exists at AIG would be avoided in the future.
Best Path Forward?
It is difficult to argue with the logic of Soros’ op-ed piece but Geithner also has a point regarding the difficulty of knowing the intent of a purchaser of a CDS. To make a ban on naked short selling practical, it would be necessary to force the purchaser to “prove” that some underlying exposure exists to the security covered by the CDS. This is simple enough when the purchaser is protecting against default of a bond that is held, but the exposure that is being hedged may not directly correspond to the underlying financial security.
For example, let’s say that someone has an ongoing business relationship, such as a supplier relationship, with a company that is in some financial trouble. In such a situation, the purchaser of a CDS may be hedging against the collectability of trade receivables. On paper, this purchaser would not own the underlying security protected by the CDS, but the CDS may in fact be a legitimate “proxy” to hedge the exposure of the trade receivables. There are obviously many other examples like this.
In my opinion, it is harmful to have regulations on the books that cannot be enforced in a transparent manner. If regulations exist to ban naked CDS positions, there must be an enforcement mechanism. If that enforcement mechanism is overly cumbersome for market participants and regulators, it may result in markets failing to function properly as well as discourage the use of CDS for hedging purposes.