Thursday, April 1, 2010

Why getting tough on CDSs does more harm than good

Original posted on Capco by Christian Weistroffer, Deutsche Bank Research:

Speculators are said to have been involved in the escalation of the Greek crisis. For this reason, politicians want to ban the purchase of naked credit default swaps (CDSs). This would not be of any help to sovereign borrowers, however.

A financial-market segment hitherto considered exotic has received broad attention in the last few weeks. There has been intense debate among politicians and the media on a ban on credit default swaps (CDSs). These derivatives which were invented, inter alia, to insure credit risks are said to have been used by speculators and thought to have been among the major factors for the increase in the risk premium on Greek government bonds. Criticism has focused on the purchase of derivative hedging instruments without the CDS buyer actually owning the bonds to be insured.

At first glance, it may indeed be difficult to recognize an economic benefit in these transactions. It is even harder to see any advantages on the basis of critics’ analogies. Their rationale is that the purchase of a CDS without the buyer actually having an insurable interest is like buying fire insurance on a neighbor’s house. The insured would benefit from the misfortune of his neighbor or, even worse, would be tempted to burn down the house. As illustrative as the comparison may be, it conceals the actual function of derivatives markets. Credit derivatives are a different story and much more than the insurance policies described above. They are instruments which allow market players to trade risks and rate them on a daily basis. CDS contracts are a hedging instrument not only against the default of a borrower but also against temporary fluctuations in the rating of his debt service capacity.

Banks enter into CDS contracts for hedging credit or counterparty exposure and reducing concentration risks in their portfolios. Institutional investors enter into CDS contracts to hedge their investments and gain access to credit risks, which allows for a better risk diversification in the portfolio. Supervisory authorities and central banks as well revert to price signals of the CDS market to assess default risks in the financial system. Better hedging possibilities for creditors indirectly also benefit borrowers. In the case of Greece, mainly banks and other bond creditors used CDSs to hedge against a deterioration in debt sustainability and thus a price decline of Greek bonds. Without this possibility, many investors – in view of the rapidly deteriorating situation – would have abstained from buying further Greek bonds or even reduced existing positions. Here, CDSs have contributed to a stabilization of the situation, not a deterioration. The positive effect was not limited to sovereign borrowers, though. Rather, CDSs on Greek government debt helped to hedge credits to Greek companies and financial investments for which no instruments exist. Here, CDS buyers had a genuine and legitimate hedging interest although they did not hold any Greek government debt themselves.

Against this background, a ban on naked CDSs as currently called for by many E.U. politicians would be counterproductive. Any CDS seller would be forced to find a buyer who is able to prove a hedging interest. Besides the difficulty to impose a uniform ban across all jurisdictions, such a measure would be associated with a considerable reduction of the liquidity and efficiency of the market. This would affect especially those who have an insurable interest. It would be harder for them to find a counterparty and they would have to accept higher costs. The question that remains to be answered is how to handle purely speculative trades which are not directly related to a hedging interest. Here, a distinction has to be made between speculation in a narrower sense and market manipulation. While speculation no doubt has an economic function, market manipulation is forbidden and should be punished. In our picture: whoever burns down the house of a neighbor, has to be aware of the fact that he will be prosecuted. Incidentally, the German financial supervisor BaFin stated recently that it could not see any indications of such manipulation in the CDS market. BaFin shares the view that risk premia on Greek government bonds were dominated by concerns about Greece’s debt sustainability, a credibility problem, and uncertainties surrounding future political measures on E.U. and domestic levels in the last few months. Rising CDS premia were attributable to increasing hedging requirements and not to speculation. In other words, the reasons for the difficulties in the refinancing of the Greek deficit are doubts about its future financing capacity – doubts which would also exist without a CDS market whose prices are a reflection of the problem and not the cause of it.

A ban on naked CDSs would have the effect of unilaterally curtailing the market. Thus, it would still be possible to bet on rising prices but a corrective force against exaggerations would be lost. Investors would be prevented from speculating against a trend and building up corresponding positions. This, however, provides the market with liquidity and ensures that prices cannot move away from reality completely. Finally, a ban on naked CDSs would not prevent the required market corrections because the sale of underlying securities would still remain an option. In a best-case scenario, upcoming market reactions would merely be delayed. As soon as they emerge, they could be all the heftier, however. In the meantime, speculators could opt for other instruments instead.

With or without speculators, markets do not function without frictions. And in segments where weaknesses are apparent a solid framework is required. Already before the financial crisis, such weaknesses in the CDS market were apparent in the areas of transparency and market infrastructure. The efforts made since then – which have been strengthened since the outbreak of the crisis – by private and sovereign agents to eliminate these weaknesses reflect that the problems have been identified and addressed already. In their own business interest, market participants are keen on a reduction of operational risks and an increase in systemic stability. Here, a flanking of the initiated measures by the supervisory authorities would make sense. Emotionalizing the debate and demonizing certain trades would not solve the problem, however.

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