I appreciate your willingness (and, jck, yours too!) to share your knowledge. I apologize if, at times, I was rude — and thank you for focusing on the point of my comments rather than the tone.

With all due respect, I don’t think we’re ever going to agree with each other.

“If there is a large body of protection sellers who don’t understand the risks of the product they’re in, CDS disrupt the market.”

You are worried about market players making poor decisions. So, of course you will be in favor of heavy regulation. I’m not so worried about that. So, I won’t be. I don’t want to spam jck’s page, but please see my articles on this subject. The CDS market has handled itself brilliantly during this crisis.

“I suspect that regulation will end up outlawing CDS without insurable interest.”

First, I hope your prediction fails, because I disagree with you (I mean that politely, sorry if it sounds rude). Second, ISDA is a powerful lobby group comprised of firms that essentially control the global flow of money. I think they’ll manage to keep the CDS market largely in tact.

What guarantees that CDS leads to more efficiency not less? I’m thinking here about the creation of products like CPDOs that appear to have driven CDS premia to unreasonable lows. If there is a large body of protection sellers who don’t understand the risks of the product they’re in, CDS disrupt the market.

I agree that in theory there is nothing wrong with CDS and that they have a place to play in a carefully regulated market. I suspect that regulation will end up outlawing CDS without insurable interest — simply because it’s too hard to prevent mismarketing of the product to underinformed money managers.

If you use the arbitrage free model for pricing CDS, the seller of protection has interest rate risk (he holds the money for possible payout under the CDS in risk free notes). His cash flows have to be very close to the underling bond or there is opportunity for arbitrage. This is a little too detailed and is off topic. If you want, email me and we’ll discuss.

Charles

CDS serve an efficient function in that they allow disaggregation of those risks.

Major confusion in your post. Of course that doesn’t follow? Why would it? And I never said the price is “so” inefficient. The CDS market exerts pressure on bond pricing because in the absence of that pressure, there would be arbitrage, which doesn’t usually exist for long.

Yes, you are right that to the corporation that issued the bond, CDS agreements naming that bond don’t add any value in that they don’t add capital. That is a valid, economic distinction between holding a bond and selling protection, as far as the underlying issuer is concerned. But so what? The CDS market helps price bonds more efficiently (e.g., without relying on the rating agencies) which makes capital markets more efficient.

As for “It should be illegal for any too big to fail firm to be a net seller of CDS,” that’s a very bold claim. I understand your concerns and I plan on writing a comprehensive piece on the systemic risks posed by derivatives. Check out my blog. I think you’ll find that you agree with me on many issues.

Financial insurance as a concept is stupid. Precisely when it is most needed the insurer is all but certain to go bankrupt. I don’t think the market could exist (no buyers) if there weren’t an implicit government guarantee to bail out the insurance sellers.

It is the government’s role in guaranteeing these private contracts (e.g. AIG bailout) that has everybody up in arms about the dangers of the market. And remember these are private contracts that as a rule do not finance any real economic activity.

As a matter of principle the government should have let AIGFP fail, while protecting the parts of the firm that were engaged in productive endeavors. As a matter of international politics I recognize that this position was untenable.

Anybody who is a net insurance seller is sure to be undercapitalized as soon as the economy hits a rough spot. Conclusion: It should be illegal for any too big to fail firm to be a net seller of CDS.

The only source of stability in financial markets is firms with strong capital positions and careful analysis of counterparties. The too big to fail concept has destroyed this stability. CDS are one of the tools used to tear down the financial system.

My apologies, jck, for taking up your blog space with my rant.