Ban Naked Credit Default Swaps, Now

Until a few weeks ago, in the world of global finance “the Greeks” were simply part of the jargon of derivatives trade. Greek letters like Gamma, Delta, Theta, Rho, Vega (standing for the Greek letter ni which is shaped as a v) traditionally are used to represent the risk sensitivities of derivative financial products, such as options, to a change in underlying parameters on which the value of the financial instrument or portfolio is dependent. Thus for instance Delta Δ measures the rate of change of option value with respect to changes in the underlying asset's price. Other fancy nicknames like Charm, Vanna, Speed, Color, Vomma and others are used. The matrix of interrelationships between four primary inputs (spot price of the underlying security, time remaining until option expiry, volatility and the rate of return of a risk-free investment) and the major “Greek” parameters is called “the Mamma” (sic). With those inputs the Black-Scholes model rules on the derivatives’ “Greeks” (outside a systemic crisis of course).

This cozy, usually highly profitable and sometimes recklessly risky world has now been upset: today the Greeks are full-bodied, larger-than-life protagonists of a drama of possible sovereign default on the global stage, with potential contagion to other members of the euro-area and the euro itself, and threats of its dissolution, to avoid which the Greeks were subjected yesterday to a third round of punitive fiscal measures. Derivatives trades, especially Credit Default Swaps, have been threatened with all kinds of regulations and prohibitions, right down to a total ban.

The FT reports that last week the European Commission invited banks and investors to discuss regulatory actions on naked CDS and other instruments that have been used in the speculation against Greece. The US Department of Justice is taking a close at trading against the euro, following reports that a group of hedge funds had met in New York to devise a common trading strategy. The Federal Reserve is investigating a number of questions involved in derivative arrangements with Greece; in general derivatives can be used to disguise debt and evade regulations and accounting rules, as demonstrated by Greece’s notorious swap with Goldman Sachs (that crucially reduced both Greek debt and interest payments; Italy did it ten years earlier with JPMorgan’s assistance). The case against credit default swaps was made forcefully by Walter Münchau in the FT of 28 February. “Jean-Pierre Jouyet, the head of France’s financial markets regulator, the AMF, called for an international agreement to give watchdogs powers to suspend CDS trading during severe turbulence, as with short-selling. He also said that questions needed to be asked about the use of CDS for anything other than covering risk, implying a ban on so-called naked CDS.” “If the Greeks hold on to the strict parameters and the markets continue to speculate against Greece, we will not let them just march through,” Jean-Claude Juncker, Luxembourg’s prime minister and chair of Eurozone finance ministers, told Germany’s Handelsblatt newspaper on 1 March. “We have the torture equipment in the cellar, and we will show them if needed” (sic!).

In a Credit Default Swap the buyer undertakes to make a series of pre-fixed (say yearly) payments until a security matures or until a default occurs (not necessarily total default, possibly even a downgrading of the credit rating associated with the security might suffice) in which case the payments stop and the seller of the CDS buys the security at par or liquidates the difference between par value and the security’s market price. Thus the purchase of a Credit Default Swap by the owner of the underlying security provides insurance against the debtor’s default; the purchase of a “naked” Credit Default Swap, without ownership of the security involved, is a straight bet that the creditor will default. The same bet could be made by selling short securities that one does not own, or purchasing a put option to sell the security at a pre-fixed price. All these transactions will lower the security’s price.

If I believe that over the next five years there is every year a 20% probability of a default occurring whereby the security will lose 30% of its value, I will be willing to buy a CDS for a fee of up to 0.20*0.30=6% of the security face value every year. Conversely, before investing in a security issued by the same debtor I will demand an interest rate spread approaching 6% with respect to a secure benchmark like German bonds: whether a new or an old issue, the security’s current price will have to yield that interest rate. In fact CDS prices and interest rate spreads exhibit similar time patterns.

Now, there is absolutely nothing the matter with insurance, as long as it is provided competitively. Nor with gambling – in principle – among consenting adults who can afford it. But suppose that the odds generated by gambling on horses might affect the race’s results, with a horse becoming all the more likely to fall and to lose the race by the very fact of odds worsening against it. Concern for racing fairness and the welfare of riders and animals would soon put a stop to horse betting.

This is precisely what happens with betting on sovereign (or corporate) default by the purchase of Naked Credit Default Swaps. Their unrestrained purchase, by driving up their price, will drive up the implicit expectation of both probability and gravity of default; will raise their spread over the benchmark of a secure loan, reducing access to new borrowing and raising its cost, adversely affecting the sustainability of debt. A default might occur, in these conditions, that would not have occurred otherwise. The best case for banning Naked Default Swaps – as well as similar bets such as short sales and equivalent options trades - is the high probability of self-fulfilling expectations of default.

An additional case is the leverage associated with the use of CDS, the dog-wagging tail involved in speculating not via investment and disinvestment in securities, but in trading derivatives on a turnover which is a tiny fraction of the value of the assets affected, often on a margin. And leverage – as John Kenneth Galbraith never tired of repeating – is an essential ingredient of any major bubble or crisis. But even if CDS sellers were made to cover their bets 100% by being forced to set aside liquid assets to the full extent of their potential maximum liability in case of default, the scale of CDS trade and with it leverage would be reduced but the possibility of self fulfillment of adverse expectations would remain. The only advantage of a 100% secure cover of a CDS sale would be the elimination of the risk of default by CDS sellers.

Freedom in the production and exchange of goods and services (including insurance services), and of production factors and their embodiment in bonds and shares, can claim a presumption of efficiency and, for some, of civil right. None of this can be claimed for the production and exchange of betting services. Normally you can only insure what you own. “Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss”. “A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.” (Münchau).

“Control of speculative activity in derivatives is feasible. This would require traders to show an underlying risk as a pre-condition to entering into a derivative contract. In the case of investors, it would also require the derivative contract being covered fully with available cash or other securities.” The unlimited inventiveness of financial markets might find ways around these controls, but that is not a good reason for not introducing them.

Having said this, three qualifications are needed:

First, there is evidence that CDS prices followed instead of anticipating interest rate spreads on Greek sovereign debt. “Certainly, at the height of the Greek crisis at the end of January, CDS did not lead the bond markets. Rather it was the other way round as government bond yields rose faster and higher than CDS.” (Gillian Tett and others, FT 1 March).

Second, in the last two months hedge funds intervened not as buyers but as sellers of CDS. Having anticipated the deterioration of Greek debt position (after all, some of them had helped the Greeks to conceal their true indebtedness...) they had purchased naked CDS on Greek debt very cheaply since early 2009, and were able to sell them in 2010 – very profitably but more cheaply than if they had not stocked up earlier on naked CDS – to banks desperate to reduce their exposure to Greek default. (Hedge Funds prosper from Greek Debt, FT 28 February). The paradox is that hedge funds, rather than de-stabilising the Greek government, have been supporting it and the banks exposed to its debt (which is probably why CDS prices followed rather than led Greek interest rate spreads). “According to Michael Hampden-Turner, an analyst at Citigroup, CDS spreads on Greece would be much higher were it not for the large numbers of hedge funds selling insurance to the banks.” (FT 28 February).

Third, a world without naked CDS trades may be better (more stable) than one with it, but the transition from a world with naked CDS (and short selling) to one without them will experience – as is almost invariably the case – transition problems of illiquidity and turbulence. Prevented from shorting Greece, speculators might turn to shorting the euro against the dollar (David Oakley, FT 1 March) or to shorting sterling against almost anything, which does raise a small query as to who was behind the Greek assault, and why. Bans on short selling have been short-lived, intermittent and fairly local; that loophole would have to be plugged. From an economic viewpoint a crisis is never the best time to introduce these kind of changes; but from a political viewpoint a crisis is the only time when it is possible to introduce them, and therefore the best time to do it is now.

An Update: Merkel calls for urgent CDS clampdown - By Quentin Peel and Gerrit Wiesmann in Berlin, Ben Hall in Paris, Nikki Tait in Brussels), FT 9 March 2010

“Germany and France are stepping up the pressure for urgent action by the European Union to regulate speculation in sovereign debt markets, in the wake of the Greek debt crisis.

Angela Merkel, German chancellor, called on Tuesday for the “fastest possible” adoption of new rules to clamp down on the most speculative elements of derivatives trading, including so-called naked transactions, which do not hedge the value of real assets. Speaking after talks with Jean-Claude Juncker, the Luxembourg prime minister, and chairman of the Eurogroup of finance ministers from the eurozone, she said: “We are all agreed that we must put a stop to financial speculation.” ...

“Differences between Berlin and Paris appear unresolved on whether to ban or merely suspend naked short selling of CDS. While Germany favours a ban, France is more inclined to give regulators the power to suspend such trading. Berlin also wants to make the market for credit derivatives more transparent by forcing buyers to register trades with a European equivalent to the US Depository Trust and Clearing Corporation.

A further restriction could force counterparties in derivatives trades to set aside capital to back transactions. “It is also very difficult to separate what a speculative CDS trade is from one that is aimed to reduce risk.” “

Bravi!