A credit default swap (CDS) is a credit derivative that shields protection buyers from the credit risks specified in the contract. CDS has acquired public notoriety in the wake of the Global Financial Crisis and the European Debt Crisis. On September 15, 2008, the $180 billion bailout of AIG thrust CDS into the spotlight for the first time, and the public was even more infuriated when it was revealed that big investment banks bought CDS to short the mortgage-backed assets they had packed and sold to their clients.
The uncovered (“naked”) CDS, which does not require buyers to have insurable interests, was castigated for fueling excessive speculation and popping the housing bubble. It is estimated that roughly eighty percent of CDS protection was uncovered at the start of the 2008 crisis. In the subsequent European Debt Crisis, the EU banned naked CDS to prevent excessive short-selling activities that targeted countries in distress. Critics of naked CDS point to its role in amplifying exposure and creating systemic risk, incentivizing moral hazard, and playing no meaningful role besides gambling. However, each of these concerns is either overstated or ill-founded.
Critiques of Naked CDS
One of the most common criticisms of naked CDS is that it significantly amplifies exposure to the referenced assets by allowing parties without any insurable interest in the asset to buy protection against it. If a credit event occurred, there would be four times the amount of monetary exchange that would otherwise take place in the absence of naked CDS. Thus, the AIG bailout consumed quadruple the amount of taxpayer money that would otherwise have been spent on the rescue. However, the risks to the financial system measured by the notional amount and the gross exposure of naked CDS are exaggerated. The cash flow from contract settlements can be significantly diminished using arrangements such as enforced netting out. Despite the huge notional amount of the Lehman Brothers bankruptcy, the cash flow of the actual settlement was relatively small. The liquidity crisis of AIG was the result of a convergence of several factors and rather unique and complex in its own kind. Naked CDS was not the only culprit responsible for its collapse, contrary to common depictions in the news. Therefore, the fear around these instruments is largely based on misconceptions.
As some opponents of naked CDS point out, the amplification effect of naked CDS can greatly undermine financial stability and pose systemic risks. Leverage is inherent in a CDS contract, enabling both the sellers and buyers to obtain greater exposure with less capital. In addition, the CDS market is highly concentrated and interconnected, with several major dealers conducting most of the transactions and having significant exposure to one another. As a result of these two features, one major credit event could precipitate a liquidity crisis that could paralyze the financial system. Therefore, critics propose that for the sake of stability, naked CDS should be banned.
While the aforementioned interconnectedness does constitute a major threat to financial stability, it does not justify an outright ban on naked CDS. The systemic risk lies not in the uncovered positions, but rather in the counterparty risk and the imbalanced bow-tie network structure. In this structure, the credit risks flow from a large number of net CDS buyers to just a few net CDS sellers, with about sixty to ninety percent of the transactions intermediated by the dealers. As a result, the net CDS sellers bear concentrated credit risks with few offsetting positions, which makes them more vulnerable to market changes. Through its close connection to the dealers, one major seller in distress can significantly undercut the credibility of their counterparties and create system-wide concerns. To that end, central clearing can address counterparty risk without prohibiting naked short selling. By transforming bilateral transactions into centralized multilateral trading, central clearing could significantly reduce the counterparty risk. In addition, it provides aggregated market data and increases transparency that enables both market participants and regulators to respond more quickly in times of crises.
Moral Hazard and Gambling
Another strand of criticism of naked CDS focuses on moral hazard; it argues that naked CDS encourages malicious manipulation of the underlying market and thus threatens normal market operations. One analogy compares naked CDS to an insurance policy in which the policyholder does not have an insurable interest. In the case of a policy on the house of one’s neighbor, the policyholder would have the incentive to burn down the house of his neighbor in order to profit from the insurance contract. Translated into the context of financial markets, buyers of naked CDS protection would be motivated to conspire to make a credit event happen by means of price manipulation or supplying disinformation. As a result, the very existence of naked CDS increases the probability of a credit event.
The last major attack against naked CDS is that it serves no meaningful purposes other than satisfying the insatiable appetite of Wall Street for gambling. Covered CDS, as opposed to naked CDS, allow investors with insurable interests to hedge against certain risks, thereby playing a socially desirable function in the financial market. On the contrary, devoid of insurable interests, the naked CDS contract degenerates into a zero-sum gambling game; one party must lose to its counterparty based on the performance of the referenced assets that neither party actually possesses. There seems to be no value added to social welfare, as the contract has nothing to do with hedging risks or funding real economic activities.
As I explain below, these last two criticisms of naked CDS are misguided. Naked CDS plays an essential role in the CDS market and the underlying spot market by uncovering more accurate information on credit risks and providing benefits including enhanced liquidity and lower borrowing costs. In addition, naked CDS can be used to alleviate, rather than exacerbate, concerns of moral hazard and price manipulation.
Meaningful Functions of Naked CDS
While critics of naked CDS correctly point out its speculative nature, they fail to recognize the vital role that the instrument plays in providing market liquidity. Speculators are active participants in the market, especially those aiming at short-term profits. They usually face fewer constraints on their trading activities than other market participants, adjusting their exposures and strategies at high frequency. Speculators’ often overconfident and impatient, behavior that further increases their tendency to trade. In this process, their vigorous searching and trading activities generate new information available to other market participants—a positive externality. Therefore, speculators’ greater freedom to trade and their behavioral characteristics make their use of naked CDS a valuable supplier of liquidity in the market.
The liquidity enhancement function of naked CDS becomes even more important outside of the traditional speculator-hedger distinction. In the oversimplified dichotomous view above, naked CDS only serve speculators who want to gamble and have no insurable interest. However, in reality, the boundary between hedging and speculation, and the definition of insurable interest are usually blurred by a wide variety of complex needs in the financial market. Hence, naked CDS also benefit transactions that are classified as hedging. For example, in imperfect hedging, shareholders of General Motors may want to hedge their exposure using CDS contracts that reference the corporate bonds of GM. There are also other more complicated strategies, such as hedging the credit risk of a certain asset using a CDS index or vice versa. In all these cases, hedging activities need naked CDS.
Therefore, additional restrictions on naked short selling are likely to hinder important hedging strategies. Instead, greater tolerance of naked short selling in the CDS market would benefit a much larger number of end users than the traditional dichotomous view of speculation and hedging would imply. More active trading activities and higher liquidity ensue from a larger and more vibrant market ecosystem stemming from naked CDS transactions.
In addition to serving both speculators and hedgers, naked CDS also enhances liquidity by protecting market makers from the concentration of unidirectional risk. The problems AIG faced in the 2008 financial crisis exemplified this point. As the figure below shows, acting as an insurer, AIG had significant net exposure of short position in its CDS contracts, while other major dealers did not have similar concentrated positions in the same direction because they both bought and sold CDS, including the naked variety. Naked CDS enables market makers to enter into different positions without holding the underlying assets, thereby neutralizing their net exposure and avoiding excessive unidirectional trading. As a result, market makers become more willing and active in accepting transactions, significantly enhancing the liquidity of the CDS market.
A Measure of Credit Risk
The second function naked CDS provides is the accurate and timely measure of credit risks. One of the most innovative features of CDS is that it separates credit risk from liquidity risk and interest rate risk. By disentangling the default risk from liquidity conditions and interest rate fluctuations, CDS provides a better measure of the credit risk of the underlying asset than the corresponding bond yield.
CDS spreads also proved to be a much timelier and more reliable indicator for credit risks than credit rating systems during the 2008 financial crisis and the European Debt Crisis. As the following figures illustrate, in the 2008 financial crisis, the CDS spread for Lehman Brother and Bear Stearns fluctuated in line with the market sentiment, whereas credit ratings remained relatively static. It became apparent that credit ratings lagged far behind market information, making only a last-minute effort to catch up with the market trends instead of generating insights to lead the market.
Some may argue that the accuracy and timeliness of CDS spreads have been exaggerated because it only surged dramatically just before the credit event – similar to credit ratings. However, this argument neglects that CDS spreads already increased by seven- to eight-fold since the first sign of weakness in the mortgage market before the failure of those two institutions. This prominent upward trend unambiguously captured the market’s mounting concerns about the creditworthiness of Lehman Brothers and Bear Stearns. In contrast, the credit rating agencies made no meaningful moves to incorporate this dramatic shift in sentiment. In addition, because nonlinearity is prevalent in financial markets, it is unrealistic to require one metric to always yield one-to-one point estimates of credit risks from start to finish without any margin of error.
Further empirical evidence for the effectiveness of CDS spreads as a measure of credit risks comes from the behavior of CDS spreads for the countries in trouble during the European Debt Crisis. The figure below compares Moody’s rating of Spain to the ratings calculated from the CDS spread of Spanish government debts. The persistent gap between the CDS’s implied ratings and Moody’s ratings again shows the trouble with credit ratings. In April 2011, Moody’s ratings for Spain was Aa2, indicating extremely low credit risk. In stark contrast, the CDS implied rating at the time was Baa2, indicating moderate credit risk that was just one sub-grade away from the non-investment grade category. It took almost two years for Moody’s rating to converge to what was already implied by the CDS spread.
Spain was not the only case in point. CDS spreads of sovereign debts regularly lead the corresponding credit rating agencies with better accuracy, especially when different rating agencies disagree with one another.
This critical credit-risk measuring function that CDS spreads perform requires an active and liquid CDS market, and such a market is only possible with naked CDS. First, naked CDS makes it more difficult to manipulate prices by building up the thickness of the market. Naked CDS serves speculators, hedgers, and market makers, thereby forming a much larger market than that confined to hedging. The diversity of CDS market participants makes it harder for a given group of traders with similar interests to dominate the market.A wide variety of end users is more likely to achieve stable trading activities that prevent large fluctuations in turnover ratios and transaction volumes. In contrast, in an illiquid market without naked CDS, the bid-ask spread would be higher, leading to an overestimate of default risks or an underestimate of recovery rates. Therefore, the CDS spread that exists thanks to naked CDS more accurately reflects new credit risk information.
In addition to greater precision in measuring credit risk, naked CDS also improves the speed and timeliness of information available to both the contract market and the underlying market. Naked CDS introduces more transactions and at a higher frequency, which motivates market participants to exert more efforts into collecting, processing, and circulating information. The race for information will not only allow CDS spreads to be updated more frequently, but also generate more up-to-date information regarding credit risks that have positive externalities for the underlying spot markets. As a result, better-informed investors are capable of making sound decisions in a shorter period. This ability could potentially shorten the length of a bubble and alleviate the severity of the resulting bust. The role of naked CDS in ensuring the information quality and timeliness in the credit market has become even more important as regulatory agencies and central banks increasingly look towards the CDS market for credit information.
Benefits for the Underlying Spot Market
Not only does naked CDS complete and improve the contract market, it also benefits the underlying spot market in several ways. First, naked CDS can take some heat off of the short-selling pressure in the underlying spot market. Economically, buying CDS protection and short selling its underlying asset are similar, but because the CDS market is usually much more liquid and has lower transaction costs, market participants who hold a pessimistic view of the underlying asset are likely to prefer CDS protection to short selling of the underlying asset. Therefore, the availability of naked CDS reduces the number of short-sellers in the underlying spot market. The downward pressure on the asset price would be lower, thereby lowering the borrowing cost. For example, from 2001 to 2002, when a number of corporate defaults threatened the corporate bond market and the broader financial system, naked CDS helped diffused the pressure on the underlying spot market by transferring the risks from loan issuers to CDS protection sellers.
However, some may argue the same logic can be applied to CDS protection sellers and the holders of the underlying assets. Because the CDS market is more liquid than the underlying spot market and does not require prefunding, investors might choose to sell CDS protection instead of holding the underlying assets. In this way, investors can attain a much higher credit exposure with the same amount of capital. This out-migration may cause a decline in the supply of capital in the underlying market and increase the borrowing cost.
While this argument raises a valid point, the potential effects of favoring the CDS market can be alleviated, or even eliminated, through the intricate interaction between the underlying market and the contract market facilitated by naked CDS. The short-sellers in the underlying spot market are much less likely to be locked into long-term positions than the buyers of the assets because short selling is asymmetrically risky and costly. As a result, in terms of their transaction preference, the overlap between short sellers of the underlying asset and the buyers of naked CDS protection tends to be greater than that between asset holders and CDS sellers. Therefore, the supposed out-migration from the underlying market might not be significant. Moreover, this out-migration could help remaining buyers in the underlying market. Because the number of CDS protection buyers increases, the supply of CDS protection increases to meet demand. While reducing the competition on the long side of the underlying market, the out-migration could decrease the CDS premium by providing more liquidity for the CDS market. The change is particularly advantageous for negative basis traders who profit from a higher bond spread and a lower CDS spread. These asset holders may be able to further increase their leverage without taking additional credit risks to absorb the shock resulting from the out-migration in the underlying market.
The liquidity enhancement function of naked CDS also benefits the underlying market by making institutions more willing to make loans in the first place. Engaging in a CDS transaction is not free; a CDS protection buyer has to make regular payments proportionate to the notional amount and post collateral at the same time. Therefore, a hedger may want to replace his CDS contracts or even terminate them if there are alternatives that are more appealing relative to the corresponding risk. Under such circumstances, this CDS protection buyer may find it easier and cheaper to exit his current positions when the CDS market is more liquid. In this way, hedging credit risks becomes cheaper and more flexible. Since the decision to issue a loan becomes less risky and costly thanks to better prices and lower transaction costs, investors are incentivized to make more loans or buy more bonds in the underlying market. In short, by increasing the flexibility and availability of CDS, naked CDS could decease the borrowing costs for the underlying market.
Although the empirical evidence is far from comprehensive, some of these theoretical effects have been documented empirically in the European Debt Crisis. During the crisis, the European Commission banned naked CDS transactions to prevent excessive short selling of the bonds of struggling countries. However, the ban failed to discontinue the short-selling activities. As long as the fundamentals of the countries in trouble did not improve, speculation persisted, and the borrowing costs remained high despite a ban on naked CDS. According to a number of economists, a ban on naked CDS of sovereign bonds actually increased the borrowing costs of the distressed nations by making the underlying market less liquid. As a consequence of a more illiquid condition, both the contract market and the underlying market also saw a delay in the price update and information circulation, which was especially detrimental during a time of crisis.
The call to ban naked CDS is mainly based on three aspects. First, naked CDS increases gross exposure severalfold and poses a systemic risk to the financial system. Second, it distorts incentives and leads to moral hazard, motivating the participants to manipulate prices or spread disinformation. Third, the contracts serve no socially meaningful purposes other than gambling. These criticisms do not justify a ban on naked CDS given that naked CDS performs several vital functions in the financial market. Naked CDS are instrumental in providing liquidity, measuring credit risks, and benefiting the underlying spot market. These functions interact with one another and contribute to lower transaction costs, better information quality, and improved risk diversification. In short, naked CDS has become an indispensable component of the financial system.
Wenda Jiang is an M.A. Economics 2021 Candidate at Duke University. He has a keen interest in the legal aspects of financial transactions and the implications for the financial system. He looks forward to getting more hands-on experiences in financial law to explore the areas unchartered or misrepresented by existing theories.
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