Should We Ban Naked CDSs?
I say, narrowly, no--that if we can get proper clearing, transparency, and capital adequacy requirements in place banning naked CDOs would not do any good and would do a little bit of harm. But it is a close call. And if we can't get proper clearing, transparency, and capital adequacy requirements in place then we should ban them.
Let's go back to first principles. The direct benefits of having more developed, liquid, and sophisticated financial markets are threefold:
They allow people to buy insurance: people facing or holding too much of one particular risk can trade piece of it away to others, and so make a win-win deal: the buyer of insurance makes a negative expected value bet but one that, given the magnitude of the distress that would be caused if the risk became reality, they are happy to make; the sellers of insurance make a positive expected value bet.
Saving and investment: people with wealth who went to spend later can make win-win deals with people with ideas who need financing to turn those ideas into productive and profitable enterprises.
People who have done research and learned information about the structure and likely evolution of the market can bet on their knowledge: they win because they make their positive expected-value bets, and everyone else wins because after they have bet financial market asset prices better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.
The disadvantages of having more developed, liquid, and sophisticated financial markets are fourfold:
People who are excessively and irrationally averse to risks can trade those risks away at a price, and so lose wealth because they are shrinking at shadows.
People are are excessively and irrationally unconcerned about risks can trade to accept those risks, and so lose wealth because they are excited by the thrill of tossing the dice.
A more developed financial market is one in which it is easier to make money by unfairly appropriating somebody else's information through insider trading.
A more developed financial market is a more fragile market: when prices move suddenly and bankruptcies and failures to deliver emerge, it destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression.
In general, you want to set up your financial markets so that they do as good a job as possible at (i) rewarding those who work hard doing research into fundamental values, (ii) matching individuals with wealth to save with entrepreneurs with ideas to try out, and (iii) enabling those who want to shed diversifiable risk to do so. And you want to set up your financial markets to minimize (i) the irrationally risk-averse's ability to throw away their money, (ii) the irrationally risk-loving's ability to throw away their money, (iii) the unfair appropriation of other people's information through insider trading, and (iv) the chance that a chain of bankruptcies and failures-to-deliver will disrupt the web of trust, cause a flight to liquidity and quality, and create a depression in the real economy.
There is an eighth consideration, however, and which way it cuts---whether it is a benefit or a disadvantage--is unclear:
- A more developed financial market increases the chance that somebody who thinks market prices are too low and wants to buy will find a counterparty who thinks that market prices are too high and wants to sell.
This eighth consideration is definitely not win-win. One of the two parties is definitely wrong--prices right now are, if they are not exactly right, either too high or too low. Both think that they are getting a good deal, but both cannot be correct. As far as the two parties are concerned, these trades are at best zero-sum and probably less than zero sum: risk is, after all, increased.
However, when all the people making too-high and too-low bets meet in the marketplace prices move until the number who think prices are too high (and are willing to put their money behind that belief) equals the number who think prices are too low (and are willing to put their money behind that belief). This reveals the balance of opinion, and so moves financial market asset prices to a place where they better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.
On the other side of the argument, somebody is holding a portfolio that is based on false beliefs about the way the world works. Such people are especially likely to fail when reality comes calling--and so encouraging these directional-bet transactions increases the chance that, when reality comes calling and when prices move suddenly, they go bankrupt or fail to deliver--and that destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression.
George Soros believes that this last consideration should lead us to limit the extent to which our financial markets are friendly to directional bets. Thus he calls for the banning of "naked" credit default swaps:
George Soros Says Credit Default Swaps Need Much Stricter Regulation: AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps....
CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them toxic is that such speculation can be self-validating. Up until the crash of 2008, the prevailing view -- called the efficient market hypothesis -- was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don't deal with the current reality, but with the future -- a matter of anticipation, not knowledge....
[B]eing long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling. The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry... exerts a downward pressure on the underlying bonds.... The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect... bear raids on financial institutions can be self-validating.... AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule.... The unlimited shorting of bonds was facilitated by the CDS market.... Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies...
Tim Geithner disagrees:
Seeking Alpha: My own sense is that banning naked (CDS) volumes is not necessary and wouldn’t help fundamentally in this case. It’s too hard to hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome.... [T]he absolutely essential thing is that there is more capital held against these positions so we never again face the situation where those types of judgments could imperil the system...
I call this one, narrowly, for Geithner: The key elements are clearing, transparency, and capital adequacy requirements that maximize the flow of information into market prices from the fact that people with money are willing to put it on the line to back their predictions and that minimize the chances of disruption of the web of trust.
