The Benefits of Naked CDS
In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.
And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago
While Sam Jones makes a great point in this post, I have a bone to pick. Please don’t take this as an attack on anything he said, his post was concise, insightful, informative and accessible. It was fucking great.
My main issue with CDS is the resistance to put them on an exchange. It’s obvious that allowing banks to manage their counter-party risk has never worked. We saw it with the LTCM fiasco, we saw it with the Lehman haircuts and we saw it with the mark-to-market CDS mess that culminated with mark-to-make-believe accounting being a totally acceptable practice.
I like CDS, I think they provide flexibility in a market that can sometimes be illiquid. I think they promote price-discovery, encourage liquidity and lead to tighter spreads on the underlying. What I don’t like is getting stuck with someone else’s counter-party risk. Having a centralized exchange for CDS would help to a degree, but the single counter-party risk is not immune to problems. The issue here is that part of the reason CDS were so profitable or so dangerous was that the private counter-party system allowed issuers of protection to set aside insufficient collateral and there is bound to be resistance to any exchange system, since the margin requirements of being short protection should, in my mind, be similar to margin requirements for the underlying, making the short protection + long risk-free collateral position essentially a synthetic of the underlying. Which is what it should be like, but it won’t, because mark my fucking words: The only reason for further financial innovation, is to circumvent leverage restrictions.
If we can get most everyone to trade CDS on an exchange, where the member firms who utilize it are the share-holders, which has a fed-mandated net-capital requirement, I am so game. This would allow member firms to operate the exchange, and redistribute the profits to themselves, making the exchange operate at virtually cost, reducing friction and encouraging liquidity. It would also make the members share the risk of setting inappropriate margin requirements, because, at the end, if the exchange went under, all the players would lose their stake in it together. Similarly, a bailout in the event of a large-scale default by one of it’s members, would probably have to come from the member firms themselves, just like LTCMs bailout.
Please feel free to let me know if I am being a moron on that last point, but it makes sense to me so far.
