Saturday, April 18, 2009

CDS Vs gambling - need for an "insurable" interest?

William Buiter draws an important distinction between using derivatives for insurance (and risk management) and for gambling, and explains why the latter is "harmful finance", and therefore needs to be regulated. He writes,

"Derivatives can be used to provide insurance (paying a premium to buy protection against a possible loss) or to gamble (paying a premium to acquire the opportunity to benefit from a possible gain). CDS can provide either insurance against loss or an opportunity to gamble. This (gambling) is because the buyer of a CDS does not need to own the underlying security or other form of credit exposure. The buyer does not have to suffer any loss from the default event and may in fact benefit from it.

When purchasing an insurance contract, the insured party is generally expected to have an insurable interest in the event against which he takes out insurance. This simply means that he cannot be better off if the insured against event occurs than if it does not occur. Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs, you are not better off than you would be if the insured-against future contingency did not occur.

Clearly, CDS contracts don’t require an insurable interest to be present. Many other derivatives likewise don’t require an insurable interest to be present. Short selling a share of common stock in the hope/expectation of a fall in the price of the equity without either owning or borrowing the stock (naked short selling) is an example of a derivative contract without an insurable interest."

Buiter therefore outlines six reasons why like gambling, "naked" position in CDS (which do not have an underlying insurable interest) should be discouraged or banned

1. Gambling is addictive

2. Moral hazard or micro-level endogenous risk - "if the insured party (the purchaser of a CDS, for instance) can influence the likelihood of the insured-against contingency (the default of the underlying security) occurring without the writer of the insurance contract (the issuer of the CDS) being aware of this, there is an obvious case of market failure and potential source of inefficiency. It’s also likely to be an illegal form of market manipulation."

3. Derivative contracts as "bearer lottery tickets" - unlike most conventional lotteries, the lottery tickets created (by the writer in the ‘primary issue market’) as part of many derivatives contracts are traded in secondary markets, sometimes over the counter (OTC markets), sometimes on organised exchanges. The owners of these bearer securities are anonymous, and ownership is not registered and hence unregulated. There is therefore absolutely no way to determine whether the current distribution of the ownership of derivative contracts is systemically stabilising or destabilising, whether it is too concentrated or too dispersed.

4. Risk-seeking by the over-confident
Most of the derivatives trading are among financial intermediaries, mainly among different banking or shadow-banking player, and are driven by overconfidence and hubris about "beating the market" among traders. Because collectively these traders effectively are the market, they are collectively irrational, as they cannot beat themselves, and "the risk ends up being concentrated not among those most capable of bearing it, but among those most willing to bear it - those most confident of being able to bear it and profit from it".

5. Churning -
Given the huge reliance on endogenous variables, derivatives trading is not costless. Scarce skilled resources are diverted to what are not even games of pure redistribution, but "games involving the redistribution of a social pie that shrinks as more players enter the game". This also affects the real economy by way of an increase in the severity and scope of defaults, which in turn involves more than a redistribution of property rights (both income and control rights). They also destroy real resources, thereby generating a negative-sum redistribution. The easiest solution to this churning problem would be to restrict derivatives trading to insurance, and the party purchasing the insurance should be able to demonstrate an insurable interest. CDS could only be bought and sold in combination with a matching amount of the underlying security.

6. Macro-endogenous risk

Financial markets being inefficient in many ways, "the distinction between fundamental, exogenous variables and endogenous variables disappears and CDS prices can become quasi-autonomous drivers of the bond prices. The redistributions of wealth associated with the execution of derivatives contracts can trigger margin calls, mark-to-market revaluations of assets and liabilities, forced liquidations of illiquid asset holdings through fire-sales in dysfunctional markets, defaults and bankruptcies. Activities in derivatives markets, including futures markets, can feed back on spot markets and real production, consumption and storage decisions."

Update 1
Andrew Leonard makes the interesting point that CDS generates moral hazard in other ways too by making the buyer of CDS less willing to cut a deal that would allow its underlying security issuer to avoid bankruptcy, because he can get paid in full in the event of that bankruptcy by collecting on the insurance policy.

Update 2 (29/5/2010)
Uwe Reinhardt has this excellent primer on naked CDS and short sales. In case of naked short sales, the short-seller borrows the security only after the sale. Although in principle the shares must be delivered to the buyer within a specified time (three days under American law), in practice that stricture often is observed in the breach. Naked short-selling is controversial, because without the constraint of actually having the security in hand, short-sellers can dump a huge volume of a security onto the market in a so-called "bear raid", depressing the security’s price in a self-fulfilling prophecy.

Similarly, a CDS sold to someone who does not own the underlying debt instrument (the “reference bond”) is called a naked CDS. In fact, one does not need to own a particular debt instrument to purchase credit-default-swap protection on it. Indeed, one does not even need to know who owns the bond. Because the spreads on a particular debt instrument change over time, one can profit (or lose) by trading swaps. Currently, the market for them is comprised predominantly of naked swaps, because multiple ones can be sold on a particular debt instrument.

CDS are a form of insurance under which the seller agrees to protect the buyer against default on an underlying debt instrument, in return for which the buyer pays the seller quarterly or semiannual premiums expressed in basis points (one percentage point being 100 basis points) per year of the amount of the debt (the "notional") being so protected. This premium is also called the "CDS spread".

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