1. By their nature, CDS create daisy chains of counterparty risk that can not be readily avoid. Essentially they are a house of cards, vulnerable to almost any disruption. Let me offer a very simple example to demonstrate this. Say we have three firms, A, B, and C that buy/sell CDS on a bond (called Lehman) in this case. Assume that B buy credit insurance on Lehman from A and sells identical credit insurance to C. Note that B's book is balanced and it has no net exposure to Lehman. A and C are also balanced with zero net exposure as is the set of firms (A, B, & C) involved.

Is this set of financial institutions safe? Not all. Imagine that Lehman fails and A has insufficient resources to cover the losses on Lehman bonds. B's book is now highly imbalanced and it may not be able to honor its contract with C. As you see, every firm is vulnerable even though B had a net zero CDS position in Lehman and the system as a whole had a net zero position. In real life, it appears that the bankruptcy of Lehman endangered AIG. If AIG had failed (and it still might), apparently PIMCO would have failed.

2. Normal insurance is written on assets that are not systematically correlated. For example, in any given year a few homes burn down in the U.S. However, home fires are somewhat randomly distributed and the premiums collected from the many (that don't burn) can cover the costs associated with the few that do burn. In theory, CDS could work this way. However, that would require that bond defaults be uncorrelated with each other in any way. As you know, bond defaults are highly correlated. What this means is CDS contracts will cost the sellers, the most money, when they (the sellers) are likely to be under the greatest financial stress. This is a formula for deep instability both in theory and in real life (now).,

Can these problems be addressed? Yes, but the solutions are not easy. Several parties have suggested moving all CDS to an exchange where the exchange would be the counterparty for all trades. This would resolve the A defaulting, bringing down B, and in turn C risk. However, the exchange might need vast resources to guarantee that all contracts could be honored in an emergency. This is a consequence of the systematic (correlated) risk of bond default.

Typically, exchanges and brokers protect themselves by demanding margin from commodity or stock traders. The amount of margin is variable and should be sufficient to protect the broker or exchange from any trader not being able to meet his obligations. By contrast, the current CDS market apparently lets financial institutions use their credit ratings as a substitute. Supposedly, AIG was able to sell hundreds of billions in CDS without posting any margin at all because of AIG's AAA credit rating (sic transit gloria).

Clearly, this is a formula for ruin. Firms such as AIG will be called upon to put up more collateral at the very point where they have the least (or none) to spare. Indeed, I saw one estimate that AIG needed to post $320 billion in collateral for its CDS positions just before it got the $85 billion bailout.

These problems could be resolved by requiring CDS sellers to post substantial margin in all cases, irrespective of their current credit rating. How much collateral? I would suggest 100%. Why 100%? Because anything less leaves the CDS potentially exposed to counterparty failure in case of a debt default. I appreciate that 100% is high and perhaps a better formula can be devised.

Note that the collateral posted for a CDS could take the form of a treasury or some other zero risk interest bearing asset. The CDS seller would continue to receive interest from the treasury for the duration of the CDS. With this structure, holders of treasuries could write CDS against their holdings as a means of obtaining a higher yield (with a consequent increase in risk).

In summation, a combination of moving CDS from the OTC market to an exchange and mandating adequate collateral in all cases could stabilize the CDS market. However, these steps are likely to make CDS less attractive for buyers (higher prices) and sellers (collateral requirements). Given that the alternative is a system that puts the entire financial system at risk (by making almost everyone "too big to fail"), I would urge these changes be adopted.

FOMALOL…This is hilarious…Cox is worried about rumors effecting the price of CDS? What about all the rumors that have been started on Squeek Blab that caused lots of players to lose money? Cox had the authority to go after those rumor mongers and did nothing! Cox is a joke and should be thrown in jail for negligence of duty.

River

Doncha just admire when such firm leadership is exhibited just in the nick of time? What a terrific guy!!!

Makes me proud to be an American.

BS. CDS do none of the above if the firms that write them are not able to make payment on them should they be exercised. And why should "default insurance" be necessary in the first place? The rate of return on the underlying investment is supposed to reflect a risk premium. That is central to how an asset market is supposed to function.

CDS is needed because borrowers default on occasion. CDS help reduce the cost of debt for borrowers. CDS would have been totally unnecessary IF there were NO DEFAULTS.

Eliminating or choking CDS is a terrible idea.

If we are going that route, I would ask: “Why does not the government ban defaults?” Totally disallow them…Say no corporation can ever file for Chapter 11. Heck, let’s rewrite our laws eliminating all the Chapters 11 and more.

That would be totally in character with our government’s actions, wouldn’t it?

CDSs

Just another host of billions – er, probably trillions – of US dollars that do exactly nothing for promoting economic growth and productivity.

Just another of the worthless, gimme-some, capitalist inventions to steal economic well-being from the American people.

Bet-swapping.
Yeah, that’s an important contribution to the general health and welfare of Americans.

Hey kids, I work in finance.
Can you spell finance?

Illegalize CDSs.
Illegalize the fat capitalist practice of creating ALL of the nation’s new money as debt.

Why don’t you guys get it?
THAT is the problem.