Monday, May 7, 2007

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."

My response:

a) High secondary and derivative market liquidity in ANY instrument allows its primary market to expand- that's the whole idea! I have been personally involved in setting up and operating secondary and derivative debt markets from scratch and I can testify that the subsequent development of the primary market involved was very fast, indeed. The increased secondary/derivative market liquidity and transparency drew in the major global players, in turn allowing the primary market to expand in size and pricing. It DOES get cheaper to issue stocks, bonds, whatever, if the secondary/derivative market is active and deep. The problems begin to arise when the process goes too far and the tail (derivatives) starts to wag the dog (cash mkt.).

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.

3 comments:

Anonymous said...

I have always been amazed how the press , even the Business press , constantly misinterprets these numbers ...... great post , and thanks to "CDS Trader "

the cds trader said...

well...i am very flattered you did a whole post on the back of my comment.

Yes, the huge increase in liquidity of the cds market over the last ~7-10 years has helped corporates issue debt more easily and cheaply, especially with the advent of CDO's allowing risk to be tranched up and placed with a variety of counterparties that want a certain type of risk profile (for example, risky but high-yielding equity tranches for aggressive hedge funds, "safe" and low yielding AAA tranches for reinsurers, etc etc).

Now, as to whether it is a bad thing that the tail (derivatives) wags the dog (bonds) as you mention...is that a bad thing? How many years have government bond futures and swaps been trading, 20 years or so? There is no doubt that the trading volumes in those markets dwarf the underlying bonds, but it seems to have worked just fine over the medium-term, I suspect because it really does allow dispersion of risk.

I have no doubt that there are risks being under-priced in the credit markets, and that credit "euphoria" is contributing to a global asset bubble, but as you say, it is more likely a symptom of other things, such as overly loose cenral bank policies and continued government-led bailouts creating moral hazard.

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