California treasurer has right idea on CDS
Bill Lockyer, the California state treasurer, is asking big banks which underwrite the state’s bonds to tell him about their role in the market for related credit insurance. It’s a fair question. And this kind of disclosure could be a better way to deal with concerns about credit default swaps than a hasty and simplistic ban.
Lockyer said in letters to six big banks that he had no preconceived notions about the banks’ role in CDS markets. But some of his questions were clearly aimed at potential conflicts that have been widely aired in recent months.
One is the extent to which underwriters of bonds may in other contexts effectively sell them short through derivatives markets — an issue that has also been raised in the ongoing Greek debt crisis. Another is the possible negative impact of CDS trading on the cost and availability of debt for California, a worry shared by corporate borrowers.
If banks cannot show they only use the CDS market for legitimate purposes of hedging and market-making, Lockyer would have good reason to exclude them from lucrative underwriting roles. If the institutions come across as self-serving, that would be telling in itself. In any case, the banks would in effect set out parameters for future behaviour that Lockyer and others could hold them to.
The Lockyer approach makes more sense than calls for an outright ban on CDS or on unhedged positions in these securities. Also sensible is the separate ongoing toughening up by regulators of collateral and capital requirements for derivatives, including CDS instruments.
Speculation and herd behaviour in derivatives markets can add to price volatility in underlying markets, but CDS instruments have genuine value for hedging and other purposes. For instance, they can reward investors who legitimately doubt the natural optimism and spin of politicians, company managers and hired bankers.
A ban or a severe restriction might make borrowers’ lives easier, but that is not certain, nor is it necessarily an appropriate goal. But customers — especially big ones like California — should press banks for disclosure and commitments about good practice. Lockyer is on the right track.