The news that Barney Frank’s committee on Capitol Hill is seriously considering banning “naked” trading in credit default swaps has us very confused. What or who is being protected from what dangers here?
The core use of credit-default swaps is clearly to allow corporate lenders and bondholders to protect themselves from defaults. But their use has proliferated in a number of unpredictable directions. Many contractual counter parties use swaps to insure themselves against other risks that cannot be directly insured. And, of course, there are traders who buy the swaps for purely speculative reasons.
What has us scratching our collective head this morning is the question of why anyone would want to ban on “naked” trading in the $26.4 trillion credit-default swaps market. We ran through a couple of possible reasons, and can’t come up with an answer.
- We’re not protecting bond issuers. A naked CDS really wouldn’t do much to protect bond issuers, and might even make credit more expensive. Because naked CDS take away some amount of counter-party risk, a ban would make a lot of contractual obligations more expensive for corporations.
- We’re not protecting CDS sellers. Most sellers of credit default swaps are pretty sophisticated (more so now that AIG is gone), so it doesn’t seem like we’re trying to protect them. No one sells CDS by accident.
- Is it buyers? We can’t imagine Congress wants to ban CDS to protect the buyers, so this probably isn’t rooted in the kind of paternalism that fosters bans on drugs.
- Regulatory arbitrage? If the problem is the use of CDS to game Basel II type capital requirements, wouldn’t it be easier just to change the accounting rules to take away this possibility?
We suspect that part of the urge to ban naked CDS trading might be rooted semantic confusion. People refer to CDS as “insurance,” so lawmakers might think that buying a swap on something you don’t own is like buying fire insurance on your neighbour’s house. Are lawmakers just confused because we use the word insurance loosely?
“We thought it was important to target this particular type of derivatives because we think it has caused a lot of harm, and we thought to get a decent discussion going, we had to go after it,” Maxine Waters says. But what harm is she talking about?
We’re serious about this question. If you understand what’s going on here, please leave a comment.
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