Satyajit Das: Controlling Sovereign CDS Trading – The Dysfunctional Debate

By Satyajit Das, author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

In an opinion piece entitled “Hedging bans risk pushing up debt costs” published on 9 March 2011 in the Financial Times, Conrad Voldstad, the chief executive of the International Swaps and Derivatives Association (“ISDA”) and formerly a senior derivatives banker with JP Morgan and Merrill Lynch, made the case against the EU ban on “naked” credit default swap (“CDS”) contracts on sovereigns.

Just as “patriotism is the last refuge of a scoundrel”, arguments citing market efficiency and the benefits of speculation seem to be the first resort of dealers. The familiar case was that prohibition was unnecessary, would decrease liquidity, increase borrowing costs and create greater uncertainty for European firms. The arguments are self-serving and do not present a balanced view of the issues.

The EU rule does not impede genuine hedging. If an investor owns sovereign securities or a firm has receivables that rely on the sovereign directly or indirectly, then purchasing protection using a CDS is permitted.

ISDA argues that banning naked CDS would have a detrimental effect on individual country’s borrowing costs. The article cites an EU study that found that the sovereign CDS market was small relative to the size of underlying bond markets and had negligible effect on credit spreads. Given this evidence, it is puzzling why banning these contracts would somehow affect pricing.

The real issue is that a ban on naked CDS on sovereigns is seen as the “thin end of the wedge”, ushering in greater control on the size of the derivative market, limits on the purposes for which derivatives are used and also on the types of derivative contract permitted. Given the substantial derivative trading profits earned by major dealers, ISDA’s position is predictable.

Historically, CDS contracts were used for hedging. Buyers of protection used these contracts to hedge the risk of default of a firm or country. CDS contracts avoided the need to transfer loans or sell illiquid bonds. It also allowed greater flexibility in hedging and offered ease of documentation. Investors could sell protection to acquire credit exposure, especially advantageous where there was no liquid market in the borrower’s bonds.

Over time, speculative factors came to drive the CDS market. The ability to short sell credit became more important. Buyers of protection, where they did not have any underlying exposure to the issuer, sought to profit from actual default or deterioration in its financial position.

Sellers of protection used CDS contracts for leverage. Selling protection on an issuer required minimal commitment of cash (other than any collateral required by the counterparty). In contrast, purchase of a bond required commitment of the full purchase price.

As trading was not constrained by the physical availability of bonds or loans, the CDS markets were more liquid than comparable bonds, facilitating trading.

The shift from hedging to speculation improved liquidity but at the cost of increased risk. The global financial crisis exposed the complex chains of risk and the inadequate capital resources of many sellers of protection.

ISDA’s argument that a ban on naked sovereign CDS will adversely affect Europe’s financial stability is disingenuous. Speculative trading in sovereign CDS is likely to be more destabilising, allowing potential market manipulation.

In practice, sovereign CDS volumes are low and large traders can influence prices, which frequently affect the values of bonds as well as CDS contracts. Commenting on the problems of AIG’s CDS positions, George Soros accurately stated the true use of these contracts: “People buy [CDS] not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. AIG thought it was selling insurance on bonds and, as such, they consider CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.” [George Soros “One Way to Stop Bear Raids” (23 March 2009) Wall Street Journal].

The response of the industry to the EU proposal reveals that participants are unwilling to admit the unpalatable realities of derivative trading. Much of what passes for financial innovation is a vehicle for unproductive speculative activity, specifically designed to conceal risk or leverage, obfuscate investors and reduce transparency. The aim is to generate profits for dealers.

However, those who believe that the ban on naked sovereign CDS is a sign that regulators and legislators want meaningful reform of derivative trading are equally deluded. Control of sovereign CDS trading is one of a series of half-baked EU measures, seeking to deal with the intractable problems of a number of heavily indebted sovereigns. Unfortunately, banning sovereign CDS contracts will not solve the problems of excessive indebtedness. The EU position seems to be if no one can see the real valuation of the distressed debt of the peripheral nations then there is no problem. It is nothing more than a diversionary tactic that also obfuscates the real issues.

Activity on all sides of the sovereign CDS debate increasingly is a substitute for achievement.