Comments on: How to regulate CDS A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: Chavez Thu, 11 Mar 2010 11:47:53 +0000 “While the value of interest rate or commodity derivatives generally adjusts continuously based on the price of a referenced asset or rate, credit default swaps operate more like binary options. A seller of CDS could one month collect its regular premium with little expectation that the insured company may default and in the next month be on the hook for billions if the insured company goes bankrupt.”–The above describes the asymmetric nature of credit risk in general: loans, bonds, not just default swaps. There is nothing riskier about writing $10MM of protection than in buying $10MM of a bond. If this ‘jump to default’ risk is too tricky for institutions to manage, then they shouldn’t own credit portfolios either, yet noone seems to have a problem with that.

By: Uncle_Billy Wed, 10 Mar 2010 17:42:28 +0000 All this dinosaur dung keeps people fat and happy as they push it around, and journalists and bloggers pay rent by talking about it, but isn’t enough enough? Get rid of it. Hedge this, swap that, securitize your mother. Sick little world.

By: vk9141 Wed, 10 Mar 2010 17:16:51 +0000 alea

This is not to say a bank can’t or shouldn’t hedge, in that the point of hedging is ( “to enter transactions that will protect against loss through a compensatory price movement”. It’s to say that under no circumstances should this substantially remove its regulatory capital requirement.

It’s one thing to use interest rate, currency, equity derivs to hedge essentially fungible risks. Not so with some of the deals I’ve seen in my recent career, whereby a large European bank buys a CDS on a pool of private, illiquid and otherwise untransferable loans.

You try and price such risk, and price the trade from both sides.

The size of such deals often ran into tens of billions notional. Ie you replace a granular bunch of credit risk with one big counterparty exposure.

How is this a good hedge?

Surely the idea of capital requirements is for these loans to be supported by adequate capital. To make sense any reduction in the first firm’s requirement should be offset by the increase in the second’s. All of a sudden the trade looks far less attractive.

By: Sandrew Wed, 10 Mar 2010 16:26:51 +0000 The empty creditor problem (one of my favs).

“Gensler’s solution is more elegant, if arguably harder to implement.”

I’ll argue with that, Felix. Gensler’s solution is “to specifically authorize bankruptcy judges to restrict or limit the participation of “empty creditors” in bankruptcy proceedings.” The implementation hurdle here is identifying who among the bondholders are empty creditors. Let’s compare that to your alternative solution “that writers of credit protection should be given a seat at the table.” The implementation hurdle here is identifying who, among all writers of credit protection, is net short protection (net long credit). The latter strikes me as a higher hurdle.

Of course, all debate about how to fix the empty creditor problem presupposes that the problem exists. The Coasean argument suggest that the extent of the problem is driven solely by market frictions (transaction costs, asymmetric info, etc.). If believed, this would suggest clearing/exchange/transparency is a sufficient solution.

By: polit2k Wed, 10 Mar 2010 15:48:50 +0000 Would a small tax on CDS trades also discourage regulatory arbitrage? The added benefit of actual tax revenues and a second pair of eyes might be useful too.

By: alea Wed, 10 Mar 2010 15:29:13 +0000 good piece except this:
“If you need capital, you should, as a rule, have capital: you shouldn’t be able to get away with buying CDS protection on some of your assets instead.”
yes, you should, that’s called hedging.