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In a paper published in the Banque de France’s Financial Stability Review, London School of Economics professor of finance Ron Anderson argues that credit default swaps have been favourable for the efficiency of credit markets.
In the paper, entitled 1007 Anderson (PDF, 115.7 kb), he weighs up the pros and cons of credit derivatives. His conclusion is that there are only two issues surrounding credit default swaps that are the subject of legitimate policy debate. The first is whether trading CDS makes a speculative attack on a borrower, such as a country, more likely. Anderson concludes that where countries disclose credible information about their future solvency, there is little scope for a speculative attack using credit default swaps.
The second issue is the tendency of credit derivatives to spread to areas where there is little liquidity in the underlying assets, such as credit default swaps backed by CDOs. Here, Anderson concludes that there is a danger of credit default swaps exacerbating the problems of these underlying products. He says that regulatory oversight on the introduction of new credit derivative products may therefore be justified.
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CFlux secondary
CLO index levels:
| Index | 6 Feb |
|
| CFlux USD AAA | ↑ | 94.9 |
| CFlux USD AA | ↓ | 81.3 |
| CFlux USD A | ↓ | 75.0 |
| CFlux USD BBB | ↑ | 74.8 |
| CFlux USD BB | ↑ |
72.1 |
| CFlux USD EQ | ↑ | 67.6 |
Well balanced, insightful and concise piece on the CDS market. Think particularly beneficial to those not fully versed in this market (like myself). Interesting how on page 6 it talks about the CDS Pricing Puzzle, and how average IG CDS prices (120bps) imply a default rate 12 times the historical average.
Credit default swaps are just the latest innovation in the never ending process of technological change in the capital markets. A process to be applauded and welcomed as the benefits out weigh the costs as the good professor points out. The issue is how to minimize the inevitable learning curve issues which will result in losses to some market participants, especially in the early stages of any innovation. I think the answer is better disclosure requirements that would quickly level the playing field between the sharks and the neophytes of the market. In the case of CDS, instead of forcing transactions onto exchanges and increasing transaction costs along the way, it would have been better to require the basic terms of all CDS contracts to be located in a central information depository that has user friendly search capabilities.
This Anderson assessment seems sober, balanced, and reasonable (and hence unusual in the recent past). I would add that Credit Events and other terms for obscure underlyings such as CDOs deserve scrutiny from ISDA and market professionals. Further, all users should understand the much greater role of effective leverage and counterparty credit risk in credit derivatives as compared to "ordinary" derivatives.