Wednesday, 10 December 2008

An end to CDS?

A while ago I stood outside a City pub having an argument with a friend about the capital markets. He said that the majority of the financial structures in the capital markets are parasitic and the industry as a whole was a busted flush without much value to society.

I disagreed: I thought that private capital markets need a variety of structures to work efficiently, and some of these would not always appear useful (like shorting) in the short-term. The alternative to the present system was not an efficient, smaller capital market, but either an inefficient smaller capital market or purely state-based provision of capital.

The conversation stays with me because it was the first time in a while I had thought hard about what the capital market is for. From my personal perspective, a big, rich capital market, full of complexity, is good for my career prospects. And as a Londoner, born and raised here, it is generally a good thing, bringing the city money, ideas and prestige.

However, these should be secondary issues. A capital market's primary function is the efficient allocation of capital, hopefully to those areas of the economy most deserving of it. The latter is clearly something we can debate forever – how to define where best for capital to go? In our present system, the private sector is left largely to its own devices while the state decides where investment should go for the half (roughly) of the economy it controls.

Over the last decade, the financial sector earned increasingly large sums from financial transactions, many of which were useful for companies, some of which were not, and were instead purely speculative. The financial industry is now looking carefully at which financial transactions are necessary and useful, and which are irrelevant, and possibly toxic.

Collateralised debt obligations (CDOs) are now seen to be in the latter category and the whole of securitisation is in doubt. Now, the credit default swap (CDS) is under scrutiny. CDS is a type of financial instrument that allows investors to buy insurance against companies going bust.

If CDS did just that, it would not be so controversial. However, CDS has become entangled in much larger systems where industry players used it to create financial monsters such as synthetic CDOs and wrote huge amounts of insurance for purely speculative purposes. A longer list of criticisms can be found here, including calls for the entire market to be shut down.

Felix Salmon, the prolific blogger at, has posted a defence of CDS. His post is interesting largely for what he doesn't say – he does not make a strong case for why CDS in particular, and derivatives in general, are good for the capital markets. Instead he appears to be saying that CDS is good for its limited purpose of credit insurance but is no good at anything wider such as being built into speculative financial structures or being used to predict default rates (note how the correlation has broken down in the graph, most likely because the tool has broken). (BTW the comments underneath Salmon's piece are probably as interesting as his original post.)

Certainly there is something wrong with CDS when gullible hacks write stories like this, saying that 'McDonalds is a better credit risk than the UK'. The story should actually be: CDS market broken: produces ludicrous results.


matt h2o said...
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matt h2o said...

Perhaps it'd be useful to draw a biological analogy. These instruments evolved and mutated and proliferated so long as there was a ready source of nutrients - in the markets, cheap credit. But like the algal blooms that fertiliser can create in rivers, too massive an expansion of the population ultimately sucked out all the oxygen and killed the fish.