CDSs allow those who hold a debt security to insure themselves against the risk of default by the borrower and thus there is a transfer of risk from the creditor to a third party willing to assume this risk. This type of financial product has become more and more speculative. Market operators bet on the realization of the risk on which the purchased products are backed.
CDs appeared on the financial markets in the late 1990s. What has relaunched the debates on the regulation of financial markets and CDs is of course the public debt crisis in Greece. In practice, the issuer of the cds undertakes to pay the creditor who purchases it the face value of the debt security in the event that the debtor goes bankrupt, in return for the payment of a premium, comparable to an insurance premium.
The premium varies not according to an a priori assessment of risk by the seller, but according to supply and demand in the CDS market. The higher the risk is perceived by the market as important, the higher the demand for cds, the higher the premium. Thus, as at 15 March 2010, the premium charged on French government default insurance coverage reached 36 points, which means that $36,000 per year had to be paid to insure a French public bond worth $10 million. In the case of Argentina, the premium requested to insure the same amount was 996 points, or $999,600.
A tool for speculation
Marginal in the early 2000s, the CDS market experienced explosive growth over the decade. At the end of 2009, the total outstanding amount of CDSs contracted in this way worldwide amounted to USD 36 trillion. Unlike a traditional insurance policy, a CDS can be acquired by any investor betting on the default of the debtor, private or public, whether or not he actually holds a debt security on the debtor in question.
Initially conceived as an effective and legitimate instrument of protection (e.g. banks or institutional investors) against a particular risk, in this case the risk of a debtor’s failure to meet its financial commitments, CDS has quickly become a tool for pure speculation.
Transposed into the field of insurance, it is as if everyone was given the opportunity to take out a policy against the damage that could occur in their neighbour’s house. This amounts to interest the purchaser of the policy in the realization of the risk against which “it is hedged”.
Greece: the incentive to default
However, in the case of a CDS, the speculative purchase of a “short hedge”, i.e. without owning the security, has every chance of contributing to the realization of the risk in question. The Greek case illustrates this point. Under the effect of massive purchases by hedge funds anticipating the deterioration of Greek risk, the increase in demand for CDS has pushed up their prices.
As for insurance premiums on the risk of a government default, the message sent by the markets to all investors is that the perception of this risk is increasing.
This deterioration in risk in turn leads to an increase in the interest rates charged by purchasers of Greek debt securities, which increases the Greek State’s financial charges and therefore worsens its situation.
Panic then seizes the markets, which begin to consider the possibility of a financial failure of a state within the euro zone itself. European, French and German banks in particular, which are heavily exposed to Greek risk, are massively acquiring CDS to protect themselves, which further increases CDS premiums and interest rates on debt.
Convinced that European governments will not let Greece down, hedge funds then begin to sell the acquired CDS at low prices, thus realizing considerable capital gains.
Anticipation or manipulation?
The existence of the CDS market facilitates access to the market for the least secure debtors by allowing creditors to insure themselves against the risk of default. The possibility of acquiring CDS short, by increasing the volume of transactions, would increase market liquidity, making it easier for anyone to hedge.
The fact that the evolution of premiums on the CDS market influences the evolution of interest rates on the exchanged securities would reflect the ability of market participants to anticipate the deterioration or improvement in the debtors’ financial situation. The CDS market would thus produce valuable information, which slower rating agencies and the heavier bond market take longer to discover.
This last point is obviously the most problematic. The hypothetical ability of markets to predict can easily mask the very real ability of a group of determined investors to manipulate prices. They can indeed play the card of destabilizing a debtor to maximize their profits.
A market to be regulated
Admittedly, the Greek crisis was not caused by CDS speculation. But it has certainly contributed to exacerbating the feeling of panic in the markets and to raising the rates paid by the Greek government on its public debt. Prohibiting the purchase of short CDSs will not solve the problems posed by the highly speculative nature of the financial markets. But this will eliminate a perverse incentive to destabilize companies or countries facing financial difficulties.
And thus to restore its legitimacy to CDS as a financial instrument by reducing it to its primary purpose of insurance. This requires, among other things, the organisation and regulation of the CDS market, which has developed over the past ten years without any financial supervision.
As demonstrated by the near bankruptcy and nationalisation of AIG in September 2008, the fact that CDSs are not defined as an insurance contract allows their issuer to avoid any regulatory constraints on the provisioning of covered risks.
This, in the case of AIG, which had not hesitated to offer CDS on securities issued in the United States on the basis of subprime and other real estate loans, resulted in a net loss on these products alone of USD 25 billion. Wished for by France, Germany and the European Commission, which want to avoid at all costs a remake of the Greek crisis, the regulation of this market cannot be achieved without the accession of the United States.
Otherwise, CDS’s demand will simply move to the other side of the Atlantic.