A CDS Witch Hunt

Story Highlights:

• Some legislators have proposed placing significant restrictions on the credit default swap market
• Those spearheading these efforts wrongly assume credit default swaps are a source of instability in the financial system
• In reality, these instruments are useful tools for managing risk, making credit less expensive and more readily available

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The vast derivatives market has become a modern-day Salem Village, but today's witch hunts aren't about harpies on flying brooms with pointy black hats. These days, the focus is squarely on credit default swaps (aka CDS). Today, the pitchfork is being wielded by Congressman of Minnesota who is crafting a bill to ban CDS trading by parties not holding the underlying debt these instruments insure.

CDS are financial derivatives that act like insurance policies on various types of debt. If an investor is worried about a bond defaulting, she can often buy a CDS to protect the bond's principal. Speculators are also active in the CDS market, looking to profit as default risks rise and fall. But CDS are unregulated and poorly understood by most people. That's probably the reason they've been treated so shabbily by the media. Often, critics of CDS cite the fact the amount of insurance issued via CDS (known as the notional value) far exceeds the value of debt they're intended to insure. But that doesn't necessarily mean CDS pose a systemic risk to financial markets. On the contrary, CDS and other derivatives provide distinct benefit by enabling investors and companies of all kinds to better manage their risk.

CDS aren't standardized and don't trade on exchanges. So an investor (normally large, institutional investors) holding a CDS contract often can't simply sell it. Instead, she'll likely have to enter into another CDS contract to cancel out the first one. These offsetting contracts mean the actual amount of risk associated with CDS is far lower than the total amount of outstanding CDS. For example, when Lehman Brothers went bankrupt last year, headlines warned of the $400 billion worth of CDS on Lehman debt that would have to be settled. The stock market plummeted as investors fretted the impact of these massive losses. But once all the offsetting contracts were cancelled out and the collateral already posted was taken into account, the actual money left to change hands was.

This ill-conceived move to inhibit trading in the CDS markets is similar to the ban on short selling in financial shares implemented last year in order to "protect investors and markets." Yet the stock market fell faster during the short sale ban than any other time in 2008. This period of less than a month (September 19—October 9) accounted for over 44% of the total drop in the S&P 500! Did the short selling ban cause this rapid decline? Probably not. But the ban sure didn't diminish market volatility as intended. The short-selling uptick rule, which necessitated an uptick in a stock's price before shares could be sold short, had a similarly negligible benefit.

So what's likely to happen if the CDS market shrinks dramatically or disappears altogether? Higher borrowing costs and less access to credit could be an unintended consequence. If investors can't offset the risk of default, they'll undoubtedly demand higher interest rates or eschew lending altogether. Obviously, that wouldn't help already constrained credit markets.

Amid the tumult of today's headlines about big new stimulus plans, this is an issue worth watching. Fortunately, the proposed bill is still in its nascent stages and is a long way from becoming law. And an effort to trade CDS on exchanges where they'll be standardized, more transparent, and largely stripped of counterparty risk has a significant head start and has been gaining traction. Moving CDS to exchanges is a far better option as it would enable these vehicles to continue to serve as effective risk-reducers.