Friday, July 24, 2009

Banning ‘Naked’ Default Swaps May Raise Corporate Funding Costs -

What's next? No "Skinny Dipping?"

Ok, before I get fired, let me explain. Naked trading is when a speculator trades a derivative security without a position in the underlying asset. For instance, if I were to short a corn futures contract, I would be "naked" since I do not own corn to sell. So prior to settlement I either have to buy back the contract or purchase corn to cover the trade. (The other type of position is covered which is when you do own the underlying asset).

Banning ‘Naked’ Default Swaps May Raise Corporate Funding Costs -
"A ban on “naked” trading in the $26.4 trillion credit-default swaps market being considered by U.S. lawmakers would have the unintended consequence of making it more expensive for companies to borrow, traders said...."
more from the article:

"Credit-default swaps were created as a way for corporate lenders and bondholders to protect themselves from defaults. Naked swaps, where the investor doesn’t own the debt on which the contracts are based, have proliferated in the market and may be prohibited under legislation being drafted by House Financial Services Committee...."

"Credit-default swaps were used by American International Group Inc. to bet on residential mortgage debt, driving the insurer to the brink of bankruptcy when it couldn’t come up with collateral as prices plunged, and regulators have blamed the market for exacerbating the financial crisis. "

additionally many have argued that naked Credit Default Swaps create an misaligned incentives. Some have compared them to buying life insurance on another person. If you buy too much you might have the incentive to hire a local hit-(wo)man.

For instance William Buiter writing in the FT:

"The obvious reason for limiting my capacity to take out insurance on the life of a complete stranger (whose life presumably has little intrinsic value for me) is moral hazard - what I will call micro-level endogenous risk. If the stranger’s life is insured for a sufficiently large amount, and if I can overcome the internal resistance of conscience and ‘thou shalt not kill’, I could arrange to have the highly insured stranger bumped off. When the probability of the insured-against contingency occurring is not exogenous, but can be influenced by the party purchasing the insurance, and if this cannot be verified and deterred by the party selling the insurance or by the forces of law and other and of contract enforcement, we have moral hazard."
If the position is great enough a naked CDS position would create a similarly bad moral hazard problem.

So what is the cost associated with banning naked trading?

CDS are not all bad. They do allow banks to offset default risk. They thus make borrowing easier and cheaper.

If naked trading forbidden, the ban would almost assuredly reduce liquidity and thus make it costlier for lenders to offset default risk.

Again from the Bloomberg article:
"...making it costlier for investors to hedge their stakes, said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, a New York-based industry group that sets rules and guidelines for the market....“Having people who are in there speculating adds liquidity and depth to the market so that anybody who is a pure hedger,...can tap that market and know they have a deep and liquid market...."

To turn back to the corn example, suppose that only farmers and large corn consumers ("bakers" in a typical in class example) were in the market. When a farmer went to trade, there might not be a liquid market so (s)he may end up selling at a lower price (of course it also works the other way and the baker may end up paying more). This makes hedging more expensive, and at the margin, would be likely lead to fewer farmers hedging which would be expected in the long run lead to fewer farmers period, and hence more expensive corn.

This is a particularly important issue since most participants in the Credit Default Swaps market are naked.

"As much as 80 percent of the credit-default swap market is traded by firms that don’t own the underlying debt, Eric Dinallo, the former superintendent of the New York State Insurance Department, estimated in a January interview."

Now the world won't quit spinning one way or the other, but that liquidity would be less seems a very logical conclusion.

And if you want more to chew on, consider this WSJ piece that reports that these new rules might be used in more markets than just credit default swaps.

1 comment:

David Harper said...

Hi FinancePro,

I agree that shouldn't be banned. However, can we agree that naked CDS speculation, which promotes liquidity (to your point), beyond a certain point is destabilizing.

Pre crisis, speculation on both sides of CDS trade was driving the basis (e.g., oversupply of protection sellers drives down the premium; driving down the CDS basis). Put more simply, when the notional market is 5X or 10X the principal, supply/demand-driven speculation is setting the CDS basis. And then, of course, feeding back on the cash market.

David Harper