Death to Speculators 2010: Credit Default Swaps

In 1997 during the Asian economic crisis, then-Malaysian Prime Minister inveighed against currency punts he thought were causing Southeast Asia's currencies to devalue more than warranted. Although he never said it--just something approximating it--"Death to speculators!" became a rallying cry for those who believed vile casino capitalists were gambling with the lives of thousands in hard-hit developing economies. In any event, Mahathir never quite lost his suspicion of currency movements.

Meanwhile, in 2010, European governments are becoming increasingly wary of sovereign credit default swaps (CDS). Basically, sovereign CDS act as "insurance" against the possibility that a government will default on paying its sovereign debt. Let us first begin with Wolfgang Munchau in the pages of the FT. Munchau cogently argues that CDS are not really "insurance" insofar as many of those taking out these contracts are not actual bondholders but, you guessed it, speculators who do not own euro-denominated sovereign debt. Hence, he classifies those as "naked" sovereign credit default swaps insofar as it is not bondholders of official debt who trade these contracts. Munchau calls for an immediate ban on "naked" CDS:

Naked CDSs are the instrument of choice for those who take large bets against European governments, most recently in Greece. Ben Bernanke, the chairman of the Federal Reserve, said last week that the Fed was investigating "a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements with Greece". Using CDSs to destabilise a government was "counter-productive", he said. Unfortunately, it is legal...

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies...

So why are we so cautious? From conversations with regulators and law-makers, I suspect they are not always familiar with those products, to put it kindly, and that they may be afraid of regulating something they do not understand...Banning products with ugly acronyms that nobody understands seems like unnecessarily hard work.

I do not want to exaggerate the case for a ban. This speculation is neither the underlying cause of the global financial crisis, nor of the eurozone's underlying economic tensions. But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.

Let's turn to another FT piece which, actually, suggests that Eurozone governments are keen on clamping down on these trades as soon as possible:

These days, however, as the eurozone reels in turmoil, it is sovereign credit default swaps that are becoming the new political villain in Europe. This is because the Greek debt crisis has prompted the French and Germans to consider banning their use for speculative bets in the markets.

Greek CDS, which measure the cost to insure debt against default, have hit record highs this year, with politicians blaming hedge funds for driving up the price of this insurance and exacerbating the financial crisis in Athens by panicking investors. The drama has triggered complaints that some ruthless investors are manipulating these markets to deliberately sow panic so that they can benefit through clever trades. This, in turn, has led to European calls for much tighter scrutiny of this market. Last month, Christine Lagarde, the French finance minister, first suggested that policymakers could clamp down on the use of derivatives linked to sovereign risk.

Since then, German officials have also raised concerns and there has been talk of an outright ban on so-called “naked shorting” – or investors using CDS to make bets about sovereign defaults, without the need to own an underlying bond. This idea is likely to be debated by regulators and politicians linked to the G20 group of industrialised nations in the months ahead...

In 2007 it cost only $5,000 to insure $10m of Greek debt against default annually over five years. This year, it reached $425,000 at one stage. Even today, for economies such as the US, UK and Germany, the likelihood of default is judged to be almost non-existent. That differs from the corporate world, where there is seen to be a genuine default risk...

Yet, until last year, sovereign CDS tended to command far less attention in the derivatives world than their corporate or mortgage counterparts. This is because the risk of default on industrialised governments was considered minimal, making the need to hedge or speculate less important. Even today, the outstanding volume of sovereign CDS is dramatically smaller than that of mortgage or corporate CDS.

However, as concern about sovereign risk has swelled in the past year, hedge funds and banks have become much more active in the sovereign CDS market – and the price of these contracts has correspondingly started to attract more attention...

One big difficulty is separating what is a speculative trade from a genuine hedge against risk. Steven Major, head of global fixed income research at HSBC, says: “For this reason, I think plans to regulate CDS are unlikely.” Other bankers say regulators could simply insist a buyer or seller has a position in the underlying reference instrument or bond before being allowed to enter the CDS market. CDS transactions could also be taxed to make it more expensive to buy or sell them.

Lawyers say regulators could target certain types of CDS trade as market abuse. Simon Gleeson, partner at Clifford Chance, says: “They’ve built the mechanism [that is, bans on short selling]. It’s a question of whether they’re going to use it in this new war. If we get the facts on the ground, that someone is known to have made huge profits, then it would give the French and German governments the ammunition that makes it highly likely something will happen.”

Some bankers also note that the CDS market is very small, relative to the government bond sector. This has meant there has been little evidence of the price of derivatives contracts affecting sovereign debt prices. Certainly, at the height of the Greek crisis at the end of January, CDS did not lead the bond markets. Rather it was the other way round as government bond yields rose faster and higher than CDS...Nevertheless, these points are unlikely to calm the fears of some continental European regulators, which worry that sharp swings in CDS prices could amplify panic in the eurozone in the uncertain months ahead.

The impediment here is identfying what is a "covered" as opposed to a "naked" sovereign CDS. What constitutes ownership of sovereign bonds or real exposure to risks of sovereign default? It's what needs to be determined in order to create effective legislation. Plus, there's the ever-thorny matter of getting a global consensus to implement these bans. Otherwise, regulatory arbitrage will remain a possibility.

Lastly, here is the chart comparing CDS and actual sovereign bond market activity: