By Sophia Grene
Published: March 14 2010 09:53 | Last updated: March 14 2010 09:53
Credit default swaps are the scapegoat du jour of politicos looking to blame evil capitalists for recent economic disasters.

They do make a good scapegoat – hard to understand, lacking transparency, seemingly motivated (on the part at least of naked CDS traders) by a desire to profit by others’ misfortune.

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And talk of large amounts of money – trillions of notional dollars – can be bandied about, which is always impressive.

A credit default swap is an agreement between two parties: one promises a stream of payments to the other, in return for which, the second party will pay out the value of an underlying credit if the credit’s original issuer defaults.

This sounds like a fairly straightforward insurance contract – but because it is a swap, it is not technically insurance and therefore there is no requirement for the buyer of the CDS to own the underlying credit or have “insurable interest” in such a credit.

This is what is known as a “naked CDS” and politicians in Europe are currently suggesting such trades should be banned, claiming they exacerbated Greece’s recent financial crisis.

But not all users of CDS are hedge funds or investment banks trying to push on-the-edge companies or countries over the cliff. Some would even question whether those malevolent players exist.

“I don’t get the impression that any hedge fund is big enough or bad enough to bully a company or economy into default,” says Thomas Ross, who manages credit funds for Henderson Global Investors.

And Luke Spajic, head of pan-European credit and asset backed securities portfolio management at Pimco, adds: “It’s not like investors pick on healthy companies or economies.”

So why might an asset manager use a naked CDS? A simple example might be a bond fund manager who owns a number of corporate credits in the widget-making sector.

If a major widget-maker were to default, the value of the fund’s investments would fall, even if it did not hold any of that company’s paper.

In order to hedge against such a risk, it might take out a CDS on the widget-maker at risk of defaulting.

Given that CDS are often more liquid than the bonds they refer to, many asset managers use them, rather than the underlying bonds, to gain exposure to a particular credit or to hedge a risk they do not want in the portfolio.

“We were pretty early adopters of CDS,” says Mitesh Shah, deputy head of fixed income at Henderson. “On our central dealing desk, it’s now about two-thirds CDS, one third physical.”

Working with CDS rather than bonds requires a great deal of attention to processing these contracts, which are still all over-the-counter rather than exchange traded, as well as a focus on risk management, but the efficiencies are worth it, he says.

The fact that CDS are not traded on exchange, or even (yet) through any central clearing house, makes it hard to get a handle on the value of CDS outstanding. It also means there is no single source of data.

To complicate matters, brokers writing CDS will usually lay off the risk by taking on an opposite contract elsewhere, so in many cases notional volumes include contracts that could be offset.

While the total of outstanding notional CDS contracts was $31,220bn (£20,768bn, €22,846bn) in the middle of 2009, the net was just $393bn of protection bought.

In fact, the notional total had fallen by more than half over the preceding 18 months, due to “continuing efforts at portfolio compression at major dealers”, according to the US Office of the Comptroller of the Currency.

This means that big dealers are trying to work out where contracts cancel out and reporting numbers accordingly.

This is all part of a concerted effort led by the International Securities and Derivatives Association to tidy up the market by encouraging brokers to rationalise their portfolios, using more standardised contracts to make that easier.

“It’s much more standardised now than it was a year ago”, says Mr Ross.

Many commentators are calling for CDS to be traded on exchange, making it easier to see at a glance what is going on in the currently murky market. That is a long way off for the moment.

A more realistic aim is to standardise most contracts and make sure they are traded through central clearing houses.

This would have the advantage not only of greater transparency but also limit the counterparty risk inherent in a swap contract, since the clearing house would bear the risk in case either side of a contract goes bust.

Bringing CDS on exchange or standardising the contracts is a long way short of banning naked CDS, though. While there is general support in the asset management community for the former, which would improve liquidity and transparency, nobody seems to think banning naked CDS trades would be helpful.

Although it might have some of the intended consequences, by damping rapid increases in spreads (the premium paid for insuring against the default of a credit likely to go bust), this would be offset by problems elsewhere.

“It might move volatility out of the credit affected – but it would probably increase the correlation with other asset classes,” says Mr Spajic.

“It might prevent the wide speculative moves we’ve seen [in CDS spreads], but it would accelerate the pace of dumping cash bonds. It would be just like the old days before CDS.”

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