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Are Credit Default Swaps the enemy?

There are moves afoot to restrict the purchasing of CDSs to those organisations which own debt issued by the underlying issuing corporation. This is an interesting concept and raises some issues that would need to be answered.

Firstly, how do you prove you own the debt? And what if you owned at the time of the trade and then sold it later? What if you borrowed the debt merely to be able to purchase the CDS? And what of the seller of the CDS? Would they have to be short of the debt? Maybe they could buy it, and then lend it to their counterparty enabling that same party to also buy a CDS? Perhaps corporate debt will only come with a CDS attached, although you might then need a CDS on the issuer of the original CDS?

And then will the debt have a ratio associated with it? There might be additional costs associated with a default, legal fees and so on. Maybe you should be able to buy CDSs up to a margin over the debt that you hold - say to 125% of the value? Or maybe you shouldn't be allowed to protect yourself completely if you are silly enough take on certain debt - perhaps the ability to purchase CDSs should be limited to 75% of the value at risk? If so, who would decide and police these ratios?

And then why shouldn't organisations exposed to corporations in other ways be allowed to buy CDSs to hedge that exposure? Customers? Suppliers? Landlords? Tax authorities? Partners?

Come on, guys!

CDSs are speculative instruments. A different way of gambling. If you speculate on an interest rate going down by buying the appropriate option, you don't have to prove you hold the currency. Ditto options on equities and exchange rates. If you buy wet weather insurance do you have to prove you don't have an umbrella? If you buy points the Oakland Raiders will score over the 49ers in a spread bet do you have to prove that you are a fan of the silver and black?

If firms can demonstrate their capital adequacy to safely participate in a speculative market place then I can't see the harm in that. Oh, capital adequacy AND organisational readiness, but that's another story.....

Hugh Cumberland

Product Strategy Director

BT GFS

1940

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