A couple weeks ago, when GE (GE) was making a bee-line towards zero, and Berkshire Hathaway (BRK) credit default swaps were blowing out, there was lots of talk about manipulation in the CDS market.
You know. A hedge fund pays dearly for CDS, then they buy some armageddon puts, maybe short a few shares and voila, the shorts are in control. GE’s Jeff Immelt made some comments about how easy it was to manipulate the CDS market, and it all sounded very similar to the scene last October, when the collapse in financial stocks was blamed on the interplay of shorting and CDS.
Of course, people think this has to be “fixed” and so you hear various calls for limitation on either the CDS market or shorting, as if that will solve the underlying concern. But as we argued last year, these are bad ideas that could easily do more harm than good: think of each of these markets as an escape valve. Close off one and just put more pressure on the other.
Zero Hedge brings up this point again, with respect to the latest volatility, offering a smart angle:
…the interplay of freely traded securities is actually a benefit: credit traders provide a perspective on company valuations (focusing on covenants, maturity rolls, leverage, and other more arcane and trivial from an equity point of view concepts) which equity traders and analyst often have missed. Curbing the CDS model artificially would simply prevent shorting credit, thereby leaving the only downside expression via shorting stocks. And as the “short stock” ban recently showed, these kinds of interventions only lead to utter chaos from price discovery opacity.
These different markets serve different purposes. Investors in them are watching different things, which is why, perhaps, bank stocks have rallied even while bank debt has cratered. Limiting one market will force investors to play in a different market as a substitute, and while that may be done curelly, that new market will not function with the clarity it otherwise would have.