A CDS is a credit derivative contract. Credit derivatives are similar to home/car insurance in offering protection against an adverse event. Consider a bank that has provided a loan to a company. A credit derivative allows the bank to insure against the adverse event of the company becoming insolvent. Thus, a credit derivative enables the bank to hedge its credit risk.
At its peak, the estimated size of the credit derivative market was about $62 trillion. Compared to this, the US federal debt is $10 trillion, GDP $14 trillion, stock market size $22 trillion, mortgage market $7 trillion and the US Treasuries market is $4.4 trillion. The size of the credit derivatives market, $62 trillion, was more than all these put together. Surely, market participants could not have been hedging credit risks that amounted to more than the size of all these markets put together. Quite evidently, these numbers indicate that a weakly regulated credit derivative market allowed market participants to indulge in substantial speculative trading.
While market participants may claim that credit derivatives are primarily used to hedge credit risk and are thus similar to home/car insurance, the possibility of speculative trading limits the similarity between credit derivatives and insurance contracts. While you can buy insurance for your own house to protect against harm caused to it, you cannot buy insurance on your bosss house. Since you do not own your bosss house, you do not suffer material consequences if it burns down. In fact, if you buy insurance on your bosss house without owning the house itself, you have the perverse economic incentive to commit arson. Substantial conflicts of interest arise when you buy insurance on an asset you do not own. In a traditional insurance contract, you have a vested interest in protecting the insured asset. Therefore, you are unlikely to gamble speculatively on its destruction.
Are credit derivatives nuclear weapons for mass financial destruction or are they akin to harnessing nuclear energy for productive uses If introduced with appropriate regulation and oversight, credit derivatives can indeed be very useful.
Introducing credit derivatives can facilitate a deep and liquid credit market. Consider a company called Techco which employs a new, breakthrough technology. Since banks may not understand this new technology, they may be loath to lend to Techco. Now consider introducing standardised CDS contracts that are traded in an exchange. The presence of more informed market participants would bring liquidity to this CDS contract and lead banks to hedge their Techco risk through this standardised contract. If banks can hedge such risks, they would be willing to lend to Techco. Thus, introduction of credit derivatives may open up availability of credit for smaller, less reputed companies and thereby lend greater depth and liquidity to credit markets.
Many start-ups often go belly up due to lack of credit despite being more efficient and cost-effective than bigger, incumbent corporations. Access to credit can be expanded by enabling banks to hedge the resulting credit risk using credit derivatives. However, the benefits will percolate over time provided there is a wide and liquid market.
Over-the-counter (OTC) traded credit derivatives pose systemic risk since bilaterally set collateral and margin requirements do not account for the externalities that each partys counterparty risk imposes on the system. To avoid such pitfalls, first, standardised instruments such as CDS and index-linked products should be exchange-traded, where the exchanges clearinghouse acts as the counterparty to all trades, well-capitalised market makers provide liquidity, and market transparency is ensured through timely dissemination of aggregate and trade-level price and volume information. Second, OTC markets that grow large should trade through a centralised clearinghouse that acts as the counterparty to all trades while smaller OTC markets should be subject to a centralised registry. Regulators should have full access to information on bilateral positions.
Finally, all financial institutions should have to disclose net positions daily.
The problem is not with credit derivatives per se but with the behaviour of users of these products. Strict regulation and oversight can help in checking such behavior. Banning credit derivatives may be like the proverbial emptying of the bathtub with the baby.
The author, formerly with JPMorganChases Global Capital Markets, trains finance professionals on derivatives and risk management. His book on credit derivatives is due to be out