The ever-astute Kelli B. has posed a question regarding the series on commodities trading, which I shall attempt to answer!

“Revelation for the day: credit default swaps are private contracts between two firms. O_O That explains so much about why attempts to mitigate the public collateral damage when volatility blows sky-high are usually impotent from the get-go: regulations wouldn’t be targeting specific industries, but rather specific private institutions (in this case, banks and other private lenders). I can see how legally that gets real tricky real quick. Question: what do you think is the best argument for regulating this kind of trading, assuming you think there’s a good reason for it in the first place?”

For those of you playing along at home, credit default swaps (CDSs) are a type of over-the-counter trade. Here’s how they work: Let’s say Jen borrows some money from a bank. The bank isn’t so sure I’m good for it, and wants to hedge its risk. Kelli B. thinks I’m probably not good for it, for whatever reason; maybe she knows how much I spend on booze. So she enters into an agreement with the bank, in which she agrees to pay the bank a monthly fee. If I default on the loan, the bank agrees to pay Kelli some agreed-upon amount. That’s a CDS.

Does that sound like insurance to you? It sounds like insurance to me, which is reason number one that I think they ought to be regulated further than they are. The Dodd-Frank bill that passed in 2010 has some provisions for regulation of CDSs, but I don’t think it goes far enough. For one, the law stops short of defining CDSs as insurance.

If an insurance company writes a policy, they have to prove they can pay out the policy if the triggering event occurs. Not so with CDSs. If anyone needs evidence as to why this is a Bad Thing, please see Bear Stearns, AIG, et al. circa 2007.

If that doesn’t ring any bells, a wee history lesson about why this was a Bad Thing: Historically, the major problem with CDSs was the utter lack of market transparency. There was, in the past, no reliable way for market participants to have all the relevant information before entering these agreements. How would you know whether a seller was solvent when, really, they had all their risk hedged by other CDSs? Many entities knew full well that they couldn’t possibly pay out all the CDSs they held if every one defaulted at once. And they also had no way of knowing how many of their buyers held CDSs with other companies, which, if THOSE defaulted, the buyers couldn’t pay them their premiums. This lack of transparency, as we’ve learned, effs up price discovery and increases volatility, such that a cascade of defaults happened that speeded, if not outright caused, the economic meltdown in the US in 2007-08.

Now, Dodd-Frank requires that all such transactions go through a central clearinghouse, to increase transparency, and requires the SEC to standardize and more carefully define CDSs. But it’s not entirely clear what this will entail. And they STILL didn’t call them insurance instruments, which is, like, SO FUCKING AWKWARD and BORING. Furthermore, several exemptions were delineated such that around 85% of current CDS sellers aren’t subject to new regulations at all, including most energy companies. LOL GOVERNMENT LOL lol l…uuugh

Here, though, is one reason why CDSs really, really bug me: the worst kind of CDS is called a “naked” CDS (you can’t make this shit up, people).  Some CDSs are “covered,” in that the buyer of the CDS has some financial interest in the underlying debt. By contrast, others are “naked,” in that the buyer has no financial interest in the underlying obligation. In our previous example, Kelli isn’t financially tied to me at all; she just thinks I’m a bad debt risk and thinks it would be fun to make some cash off my dereliction–that’s a naked CDS.

In both cases, it can be argued that there’s a moral hazard involved (Murdock 2013). In covered CDSs, the buyer has more information than the seller, because the buyer does have an interest in the underlying debt. That seems weird, because it puts the seller at a disadvantage. At that point, it seems absurd not to say that this should be regulated like insurance. Insurance companies get to know stuff about what they’re insuring. I have to pay extra to my insurance company because I’m a godless heathen smoker, and I’m required to tell them that kind of shit. Why not sellers of CDSs?

In the case of naked CDSs, the moral hazard is much clearer. The buyer of a naked CDS wants the underlying obligation to default. You can see how that lays open the possibilities for all kinds of hijinks. Kelli could start doing all kinds of mean shit to me to make it more likely that I’ll default, like driving down my stock price, so that she can roll around in a big pile of money while I cry in the gutter. Or, she could get a friend of hers to get the bank to take on my loan without telling them I suck at paying loans, and then she and her friend could buy the CDS together, which makes the bank happy, until I default, then the rolling and the crying. That’s pretty much what happened with Goldman Sachs. But this still isn’t my biggest problem with these.

The HUGE problem:  the absolutely staggering breadth and scope of these things is, well, absolutely staggering. At one point, the total value of all outstanding CDSs was greater than the amount of money actually in existence (insofar as money can be said to “exist”). If all CDSs in the US were to default right now, it would total more than 2 times our GDP. That’s just nutballscrazy!

It’s also horrifying to me that you can take outCDSs on the debt of sovereign nations. Like, say, oh, I don’t know, Greece. This practice distorts perceptions of market economies, making it MORE likely that they’ll default. How does that happen? Well, if you see that a bunch of people are taking out naked CDSs on Greece’s debt, you’re likely to perceive that Greece is about to default, so you might join in on a “run” on their debt. Uncool. This exacerbated Greece’s woes substantially. I don’t think we should be able to do that.

Neither does the EU–they banned naked CDSs on sovereign debt. I think we ought to follow suit, and I think we ought to ban naked CDSs altogether. The opportunity for price distortion is too great, and we’re the ones who end up holding the bag, not Wall Street.