Critics of credit default swaps have got it wrong

by Conrad Voldstad

Financial Times
November 21, 2011

There has been so much criticism of credit default swaps (CDS) of late that you would think no one was using them any longer. Yet today we see net open positions of $2,900bn, up from $2,400bn at this time last year. This simple fact belies the inordinate amount of misperceptions surrounding the CDS market. In spite of all the rhetoric, CDS remain a robust and effective financial tool for hedging risk or taking on exposures.

The most recent strain of criticism focuses on sovereign CDS and started with the unproven notion that CDS prices dictate the prices of sovereign bonds. In the case of Greece, this was imagined to have an adverse impact. One need only to note that net open positions in Greek CDS are $3.6bn – while the Greek bond market is about $450bn – to understand the lack of logic of this argument. How can the minuscule CDS tail wag the mighty Greek Cerberus?

In addition, have the critics ever heard of arbitrage? If one market is mispriced relative to another, it is simple to buy one and sell the other. This eventually brings prices into alignment and promotes market transparency and efficiency. But despite numerous findings by the European authorities, it looks like so-called naked sovereign CDS will be banned soon. As we all know, this will certainly not be a silver bullet for Europe’s debt problems.

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