I just read another attack on the use of “naked” CDS (credit default swaps). This use of the word is potentially misleading – maybe deliberately so, in order to tarnish CDS by association with naked shorting of ordinary securities.
Naked shorting means going short a security when you haven’t actually borrowed it. Normally you borrow a security in order to sell it. At that point you’re short the security because you owe it back to the person or organisation you borrowed it from. Crucially you owe the security, say one share in BP, rather than a financial amount. If the price of BP shares falls, you buy a share in the market at the lower price, repay the loan in kind and pocket a profit (net of any transaction costs, which are quite low on liquid securities).
Naked shorting is illegal in most jurisdictions because you are selling something that you don’t actually own, which is a form of fraud. You obviously have to buy the security at some point to provide to the buyer and you’re speculating on the price falling in the short time available. If you can’t buy it or don’t, the real buyer finds you can’t deliver and suffers as a result. So it’s banned.
CDS are derivative securities that you can buy or sell. If you buy a CDS you buy protection against a credit event (eg bankruptcy) of the entity covered by the CDS. You therefore are short that credit, because you get a payoff in cash or kind if the credit goes wrong. This is legal and legitimate (in my view). It’s not “naked” in the sense of naked shorting because there is no pretence or risk to the counterparty.
What the critics have in mind is the comparison with insurance contracts. CDS are often described as a form of insurance: something bad happens, you get paid compensation. The difference is that you normally cannot take out insurance against an event that you have no interest (ie stake, exposure) in. So I cannot take out life insurance against somebody else, not least because I’m then in the morally questionable position of standing to gain financially from their death. That could even lead me to try to hasten their demise, a form of moral hazard (post-contractual opportunism).
There is currently no restriction on CDS owners having no interest in the underlying credit. So I can buy CDS protection against say Irish sovereign bonds defaulting, without owning any of the underlying bonds. So it’s not insurance in the traditional sense of protecting against a loss. It’s going short something I don’t own. Is this defensible?
Like most economists I reckon that it’s mostly a good thing if market participants have a wide range of securities through which to express their views. CDS spreads (costs) provide a useful form of price discovery of the market’s estimate of default probabilities. Informed credit analysts can put their research work through CDS trades, which should move prices more quickly closer to their fundamental value than in the absence of CDS. It is possible to short bonds in the conventional way (borrowing then selling) but it’s costly and inhibited by the lack of bonds available to borrow. Stock borrowing by comparison is quite a liquid and low cost market.
Also, investors may use CDS as part of a wider portfolio trade. So I may not own the actual underlying but the CDS may represent a hedge against some other losses, rather than a pure speculative directional trade. But in my view, such speculative trades are fine so long as they comply with normal rules of good market behaviour.
People are free to criticise CDS and other derivative securities but calling them naked is a cheap shot and doesn’t engage with the real debate about whether they are really harmful or not. Most derivatives were unpopular or controversial in their early years, and most were associated with scandals of mis-selling or inappropriate use (Orange County, Hammersmith & Fulham etc). But once they settle down they become a useful part of the financial tool kit and I expect CDS will eventually be seen in the same way.