Perception Creates Reality

A reader commenting on the previous post on CDS asked: "... if two people have a bet on a football match, does that affect the result?"

This is a seemingly innocent and deceptively easy question;  but, in fact, it is very difficult.  To answer it we must touch upon the very core of our understanding of the physical world, since it is another way of expressing a fundamental premise of quantum physics/mechanics: Does the mere observation of an event alter its outcome? (see Schrodinger's Cat).

My opinion is that yes, observation certainly affects the result.  I have already dealt with the subject from the financial markets point of view in a series that appeared exactly one year ago (Neo At The Quantum Casino - Part I, Part II, Part III).  In addition, another post dealt with the Quantum Economy (The Economy as Schrodinger's Cat).  I believe that financial markets provide the best empirical validation of this axiom because perception of a fact shapes their action, well before actual fact.  Furthermore, perception very frequently forces a fact into existence -  for example, a run on a bank.

Now, as to CDS being bets.  Yes, of course they are, in the narrow sense.  But, they are much more than a simple up/down wager of the black/red kind at the roullette table.  For one thing, CDS can also act like bonds on steroids: to the seller, a CDS provides an upfront lump sum plus a steady stream of income with little or no principal invested, depending on margin and capital adequacy requirements.  As such, CDS are a particularly pernicious way to inflate systemic leverage and further expand the debt bubble, outside any significant control or oversight from monetary authorities (shadow banking).  I say pernicious, because unlike most straight debt, proceeds from a CDS do not go to fund the "real" economy but stay within the shadow banking system.  They are just more (and more easily toppled) financial domino instruments.

Unlike a straight bond portfolio, a portfolio of CDS is, by definition, much more volatile. Because CDS are so highly leveraged a small movement in price causes large gains or losses.   And therein lies the perception problem, because a volatile CDS market produces - by necessity - increased volatility in the underlying bond market;  CDS and bond markets are interconnected like communicating vessels. A perception of higher or lower default risk is instantly communicated to the bond market via the CDS channel.

The end result is that the CDS "tail" is wagging the bond "dog".  A relatively small, inefficient, opaque and highly leveraged derivatives market controlled by a mere 4 or 5 trading banks, can wreak havoc with the biggest, most important securities market in the world - that for bonds.

Let's put it into casino terms: you are sitting on a ho-hum blackjack table where the action is small and slow.  Suddenly, a bunch of well-known high rollers stops by and starts side-betting heavily on your hand.  Would that affect your judgement and the way you place your own bets?  Of course it would..