Banning Naked CDSs

A little late in the posting, but Brad Delong on banning naked CDSs:

I say, narrowly, no–that if we can get proper clearing, transparency, and capital adequacy requirements in place banning naked CDOs would not do any good and would do a little bit of harm. But it is a close call. And if we can’t get proper clearing, transparency, and capital adequacy requirements in place then we should ban them.

Let’s go back to first principles. The direct benefits of having more developed, liquid, and sophisticated financial markets are threefold:

  • They allow people to buy insurance: people facing or holding too much of one particular risk can trade piece of it away to others, and so make a win-win deal: the buyer of insurance makes a negative expected value bet but one that, given the magnitude of the distress that would be caused if the risk became reality, they are happy to make; the sellers of insurance make a positive expected value bet.
  • Saving and investment: people with wealth who went to spend later can make win-win deals with people with ideas who need financing to turn those ideas into productive and profitable enterprises.
  • People who have done research and learned information about the structure and likely evolution of the market can bet on their knowledge: they win because they make their positive expected-value bets, and everyone else wins because after they have bet financial market asset prices better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.

The disadvantages of having more developed, liquid, and sophisticated financial markets are fourfold:

  • People who are excessively and irrationally averse to risks can trade those risks away at a price, and so lose wealth because they are shrinking at shadows.
  • People are are excessively and irrationally unconcerned about risks can trade to accept those risks, and so lose wealth because they are excited by the thrill of tossing the dice.
  • A more developed financial market is one in which it is easier to make money by unfairly appropriating somebody else’s information through insider trading.
  • A more developed financial market is a more fragile market: when prices move suddenly and bankruptcies and failures to deliver emerge, it destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression. [link]

I agree. He goes on to quote Geithner:

My own sense is that banning naked (CDS) volumes is not necessary and wouldn’t help fundamentally in this case. It’s too hard to hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome…. [T]he absolutely essential thing is that there is more capital held against these positions so we never again face the situation where those types of judgments could imperil the system… [link]

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1 comment for “Banning Naked CDSs

  1. September 12, 2011 at 12:06 am

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