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De-Detour: CDS Nudity on the Exotic Fringe

posted by Anna Gelpern

A recent FT Editorial implicates a topic IImage1 -- basis risk in emerging markets (EM) credit derivatives.  The problem is this:  If you want to buy protection against default by a big U.S. firm--say, GM--you buy a CDS contract on a GM bond.  But even in the leading emerging markets, it is often difficult to buy protection on major corporate credits, especially if you want to hedge against default on local-currency or other non-dollar/euro/yen obligations.  This is because local financial markets are relatively thin.  Your choice then is to buy a liquid standardized instrument, such as a CDS on foreign-currency sovereign debt, or to negotiate an expensive bespoke contract with a party willing to take the precise local risk off your hands.  If you opt for the liquid standardized sovereign CDS, you get partial protection.  This means that if your borrower defaults but the government is still servicing its dollar-denominated foreign bond, you cannot collect.  Herein the basis risk.  Note that even if you were able to arrange bespoke protection, you could be taking on more counterparty risk, since the only people willing to insure illiquid local instruments might be local institutions more exposed to measures such as capital controls ... or risk-hungry fringe elements that might flake out on you.

How is any of this relevant to the current debate on regulating "naked" CDS, or credit protection not matched by exposure to the underlying credit (aka fire insurance on your neighbor's house)?  It goes to the difficulty of defining the subject.  A CDS that might appear naked at first blush could in fact be partially clothed; and instead of encouraging better hedging, we might end up eliminating what partial protection is available in less liquid markets (damage insurance on your block?).  Not to say that EM basis risk should even remotely drive the discussion, but the example does expose the challenge of figuring out not just the legal terms of the regulated instruments, but the often less-than-intuitive ways in which they are used.


Why should we structure our financial system just so somebody "wanting to buy protection against default by a big U.S. firm" can do so? Why not just let that person do what they did before CDS became widely sold for such protection (i.e., as recently as ten years ago)? Without the ability to hedge with CDS, naked or not, the price of protection against default was built in to the price of the bond or debt created. What do we gain by allowing banks to reduce that price with the appearance of insurance that is not really insurance?

If lending to GM is risky, the market simply charges a higher interest. If GM cannot afford that rate of interest, it will not be able to borrow. Why is that a bad thing? And don't tell me it's bad because GM can't "grow". If GM can't afford to grow through debt, more financially sound automakers will fill the void, and isn't that what the markets should do --- reward the prudent and punish the profligate? As far as I can tell, the whole purpose of CDS hedges is to obfuscate risk making it very difficult to price. Indeed, that is how toxic MBS was sold with AAA ratings by agencies who clearly had no real understanding of what it was they were rating.

At least the scientists who created the atomic bomb claimed that they never wanted to see it used again. Our financial institutions, having blown up the world once, seemingly can't wait to light another fuse.

The non-speculative market for naked CDS may be wider than just Emerging Markets. A recent article in the Virginia Law & Business Review states that landlords in large net lease transactions could buy a CDS to compensate against damages arising from lease rejection in bankruptcy. I suppose a large supplier to GM might cover itself against default by buying a naked CDS related to GM bond.
Estimates are that naked CDS constitute 80% of the market in CDS. In the early 2000s, the outstanding value of CDS in the debtor Delphi greatly exceeded the face amount of its bonds. That is a lot of unregulated protection (insurance?) that could cause cascading defaults and systemic risk. On the other hand, I believe (not completely sure) commodity futures require no ownership of the underlying commodity. Perhaps the difference is that key financial institutions have not dabbled in futures like they did CDS?

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