In my view the biggest problem with this market has always been that it has allowed the creation of potentially devastating systemic risk by failing to distinguish which writers of CDS are good for the money, and which are not.
Having said that, the huge increase in concerns about counterparty risk over the last year already means that CDS market players are paying a great deal of attention to who is taking the other side of their contracts. Still, it would be a very good idea if these risks could be mitigated further by a move onto exchanges, with central clearing and a major reduction in counterparty concerns. I’m surprised that the authorities haven’t moved more quickly to enforce this.
What some in authority are proposing to do is quite different. Former SEC Chairman Cox talked last year of banning CDS position-taking when the investor doesn’t own the underlying bond, and now we have effectively the same proposal from Congressman Peterson.
I think this is a really terrible idea. It’s similar, as its proponents admit, to the short-selling bans introduced in the autumn. Why is it bad? First, the short-selling bans didn’t work. Take a look at the share prices of the banks before and after the restrictions were introduced. Here’s one version – there are plenty more charts like this on the web.
Second, and much more importantly, the ability to short is directly related to the liquidity of the markets. Introduce constraints on market participants’ ability to hedge themselves and you will see bid-offer spreads widen and the depth of markets decrease, affecting everybody. Lisa Dallmer made precisely this point in her interview with IU.eu, published yesterday.
The credit markets are already in bad shape, even if conditions have improved a little since October. Banning “naked” CDS writing would in my view make things even worse, and intensify the crunch.
Finally, and most fundamentally, this type of restriction would reinforce many people’s opinion that Wall Street is a rigged game. There are few restrictions on the markets during the bubble phase, but when the inevitable downturn arrives, those merely pointing out that certain companies are in trouble get the rap, not the people who are really responsible, the managers of those companies and the shareholders who were asleep on the job.
Fixing things in this way is what Communist regimes always did very well, and we all know the results. Do we really want free markets, or do we want them only when we’re winning?
Let mismanaged companies fail, and leave regulation to enforce a level playing field and transparency, nothing more!