Further On CDS...
In response to a previous posting on CDS creating liquidity/debt, a CDS trader (known simply as "the cds trader") was kind enough to leave the following comment on 4/29, which I have just noticed. I am reproducing it and give my response below:
The CDS Trader said:
"notional amount of CDS is over-hyped from those without proper knowledge of this market.
the "liquidity" in this market merely allows efficient transfer of risk, hopefully to those able to bear those risks (although I'm sure plenty of counterparty's are not in that position!). it doesn't exactly mean debt creation. if the SP500 had 2bn contracts traded daily instead of 1bn (i don't know what the exact numbers are), you wouldn't say that companies can issue equity any cheaper? in the same way, it is the wrong argument for credit derivatives.
and as for the market value of CDS contracts...how can it be anything other than zero net-net? each trade is a contract between 2 counterparties (c/p), and so one c/p will be down the same amount that the other is up.
the growth in CDS is the most over-hyped point from the conspiracy theorists. and trust me, I have been a CDS trader since the market was in its infancy in the 90's, AND i am incredibly bearish on global liquidity/asset values. think you should be looking elsewhere for negatives though."
b) Net-net everything cancels out: one person's asset may be another's liability - that's not the issue here (though it took humans millennia to invent and apply the double-entry accounting system, so it's no as self-evident as it appears). I was referring to the creation of income streams (CDS premia) and potential default exposure in vast excess of the original bond issuers' obligations. As you know, there are many more CDS's outstanding (notional) on individual issuers than their underlying bond obligations. This process does not merely transfer risk, it creates excess risk. Just because that excess risk is then netted out between counterparties (of dubious ability to withstand it, as you mentioned) does not mean net systemic risk is zero.
c) I sincerely hope I do not sound like a conspiracy theorist! And I know for a fact that Buffett ("instruments of financial mass destruction") isn't one either; maybe he is getting too set in his ways and conservative in his old age, but I seriously doubt it.
d) The rise of the CDS market is not the sole creator of potential trouble in this over-indebted and asset-inflated world. Indeed, CDS's are a symptom of high debt, not its cause. With all this liquidity (i.e. debt) floating about, a way HAD to be found to shift credit risk around and make it more bearable by the economy as a whole. It's just that, in my opinion, the process has gone so far now as to pose added systemic risks, as I pointed out above.
In closing, I thank "the cds trader" for his/her valuable input and invite further comments.