FT Dizard says "Kill CDS market now"
Thought provoking article by Dizard in the FT.
He lays the blame at the feet of Credit Default Swaps for the negative feedback loop afflicting the current financial world.
Just like bank runs of yesteryear brought the banking system to its knees during the 30's, CDS capital raising are running on illiquid assets. Just like the FDIC was legislated to prevent bank runs, I expect someone will look into this soon.
Hedging a credit default with a CDS is a valid excercise of risk transfer imho. However side bets (when you buy a CDS without holding the underlying bond that is supposed to default) INCREASES the systemic risk as bad debt is multiplied. If there is a bad debt of $1 you find yourself with a payout of N, N being the number of CDS contracts being written. This is why the CDS nominal world is many times the real economy. They are therefore agents of instability in the dynamic feedback loops.
SIDE BETS ON CDS SHOULD BE BANNED, STRAIGHT CDS COULD STILL HAVE A VALID ECONOMIC FUNCTION.
He lays the blame at the feet of Credit Default Swaps for the negative feedback loop afflicting the current financial world.
Consider capital raising. Writers of protection in the CDS market must now hold increasing amounts of cash as margin against the probability of default for the "reference entities" or borrowers they bet on. This has led to the sale of tens of billions, if not hundreds of billions, of dollars, euros and pounds worth of securities to raise that cash.
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Some of those buyers hold actual exposure in the form of bonds or supplier contracts; many more have just made side bets.
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So CDS dealer sales of Citigroup equity through derivatives means higher equity volatility, then higher CDS spreads, leading to more margin calls, leading to more sales of bank stocks . . . This has become a system-wide tail-swallowing exercise in lunacy.
Just like bank runs of yesteryear brought the banking system to its knees during the 30's, CDS capital raising are running on illiquid assets. Just like the FDIC was legislated to prevent bank runs, I expect someone will look into this soon.
Hedging a credit default with a CDS is a valid excercise of risk transfer imho. However side bets (when you buy a CDS without holding the underlying bond that is supposed to default) INCREASES the systemic risk as bad debt is multiplied. If there is a bad debt of $1 you find yourself with a payout of N, N being the number of CDS contracts being written. This is why the CDS nominal world is many times the real economy. They are therefore agents of instability in the dynamic feedback loops.
SIDE BETS ON CDS SHOULD BE BANNED, STRAIGHT CDS COULD STILL HAVE A VALID ECONOMIC FUNCTION.
Comments
If you buy a put on a stock, the bank selling it will hedge it's position dynamically by selling the stock. When the option is at the money, it will typically short half the amount. As the stock price fluctuates, it shorts more or less. The lower the price falls, the more stocks the bank needs to short, but it is ultimately bounded by -1. The lower the price of a stock, the less additional shorting you need to do when it falls lower. The second derivative of the option price with respect to stock price, the gamma, is positive.
A CDS is hedged by shorting the underlying bond. But as the bond goes to 0, the hedger needs to short more and more, which further depresses the price of the bond and encourages more selling.
Dynamic hedging of CDS is inherently unstable. Perhaps even more than CDS entered for speculative purposes with cash margins. The margin is negotiated based on that investor's own credit. Caveat emptor.