Thursday, March 5, 2009

The Debts Of The Spenders: CDS Exchange Needed Now!

CDS traders argue that in the absence of CDS the bond markets will operate as a functional equivalent. Under this blissful scenario, the debt of companies and countries will trade at levels set by the market and by rating agencies.


The bond markets - like CDS - are relatively illiquid. With the exception of sovereign debt (e.g. treasuries) and large corporate issues (e.g. GE), the bond markets remain a relatively illiquid realm of slothful, secondary transactions. The muni bond market comes to mind here w/its history of flagrant abuses in underwriting, rating agency payoffs, political posturing by state authorities, and other sleazy tactics that obfuscate transparency. As for the rating agencies believe them at your own peril. After all, the concept of rating agencies seems to be pointless when a Aaa rated issue has its bond CDS trading at Fff status.

I am not against the concept of a CDS per se.

However, it is more than obvious at this point that the CDS market is is serious need of more regulation and transparency.

A CDS exchange would accomplish the goals of creating much needed transparency. The CDS exchange would post a schedule of rates for each rating grades AS SET BY THE MARKET. Trades would be marked to market on a DAILY BASIS. Funds would also settle quickly such as within 2-3 business days. And finally, a central authority would ensure that there is an actual counterparty capable of resolving outstanding issues.

I rarely talk about trading on this blog since this is more of a macro-economic focus here. However, I have to bring in examples from my own personal trading experience in order to adequately explain the disjunction.

The futures and options exchanges operate on a model of transparency. The shenanigans that brought down the OTC derivatives desks of AIG, Lehman, Bear Sterns, Citigroup, and other former Masters of the Universe would NEVER be tolerated in the futures pits. Imagine being able to postpone assignment for an entire quarter! W/barely any government supervision!

It is also a tragedy that NON-OTC traders (such as equities and futures) working in other divisions had to suffer for the mistakes of their fellow employees.

That is what the CDS contract writers are essentially doing. They wrote a whole bunch of naked options and are now being assigned. Unfortunately, the payout amounts far exceed anything available in their coffers through the magic of leverage. Futures and options brokers would have issued thousands of margin calls by now and driven bankrupt companies into true insolvency. Instead in the CDS fantasy universe the taxpayers . . . are forced to pay for the gambling debts of undead financials.

As a futures and options trader I DO NOT expect others to pick up my trading losses. The entire concept is alien to me and to other non-OTC traders. Leverage is certainly available but the central clearinghouse and mark to market ensure that few traders get out of hand. There are also firm regulatory bodies in place such as the SEC and CFTC to ensure a modicum of responsibility. Those that push the boundaries get punished swiftly - if not by the authorities then by the markets.

The reason why CDS exchanges do not exist yet is because they threaten to make the ratings agencies redudant. After all, what is the point of having fictitious ratings when traders aka THE MARKET can determine price?

A CDS exchange also threatens to reveal the true extent of governments' fiscal profligacy by stripping sovereigns of their fictitious ratings. If we had a CDS exchange, California would be trading at junk bond status now and the USA barely behind. A true CDS exchange would thus encourage fiscal responsibility from politicians by curbing reckless spending. While the authorities have been publicly supportive of such a measure, the blueprints for a CDS exchange(s) remain on the drawing board.


In Debt We Trust said...

I am reposting this article from accrued interest's blog. Please read both the article and comments as the writer and posters are very knowledgeable!

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