Batchimeg Sambalaibat,
Based on: Review of Financial Studies, 2022, 35 (5), 2525-2569 DOI: https://doi.org/10.1093/rfs/hhab094
Credit default swaps (CDS) are thought to be harmful to the issuers of the underlying bonds. However, allowing investors to buy CDS improves rather than worsens the market for the underlying bonds. Both the liquidity and the price of the bonds increase. As a result, introducing CDS benefits rather than harms the bond issuers.
During the 2008 global financial crisis, CDS were labeled “the bet that blew up Wall Street.”[1] Warren Buffet called them “financial weapons of mass destruction.” This rhetoric stemmed from the fact that systemically important financial institutions—the likes of Lehman Brothers and AIG—had sold massive volumes of CDS. Using CDS contracts, they had bet that the housing sector and debt instruments tied to the sector would continue to increase in value. When the housing sector instead collapsed, so did these institutions. Their collapse in turn threatened to bring down the entire financial sector.
The controversy surrounding CDS reached a fever pitch during the 2010–2012 European sovereign debt crisis. European regulators blamed them for exacerbating the sovereign debt crisis and ultimately banned naked CDS purchases in which the CDS buyer does not own the underlying bonds.
Credit default swaps are insurance-like derivative instruments that protect against debt default. In a CDS contract, the seller of the contract agrees to pay a lump sum amount to the buyer of the contract in case some entity (e.g., the Russian government or Credit Suisse) fails to pay their debt. In return, the CDS buyer pays the seller a periodic fee. The most basic use of CDS is that they allow bond investors to hedge against default risk.
But what makes CDS useful to investors—and the reason the global CDS market ballooned to a $62 trillion market at its peak—is that investors do not have to trade the underlying bonds to trade CDS.[2] Such trades are referred to as “naked” CDS trades. This is like two neighbors getting together and one selling insurance to the other against a house in their neighborhood burning down. Any two parties can wager with each other that Russia, for example, will default on debt payments to its bond holders. The party selling CDS bets that Russia will not default. The side buying CDS bets the opposite—Russia will default. The party selling CDS gains a “long” exposure to Russia's default risk; the party buying CDS is “short” Russia's default risk. Such speculative CDS purchases in which the CDS buyers do not own the underlying bonds (i.e., naked CDS purchases) were at the heart of the CDS controversy and the ultimate ban of CDS trades.
So how do naked CDS purchases affect the underlying bond market? Were naked CDS bans justified? Since all derivative products, like CDS, allow long and short positions on the underlying asset without trading the underlying asset, the answer matters for the $600 trillion dollar derivative asset class.[3]
I find that short positions through CDS contracts increase the liquidity and price of the underlying bonds. To see why, consider the following backdrop. Typical bond markets are notoriously illiquid. Individual bonds on any given day can observe zero trading activity. This lack of liquidity stems from the fact that, first, the number of bonds available for trade is limited. Second, anticipating that it will be difficult to find someone selling bonds, potential bond buyers stay out of the bond market. The lack of trading activity manifests as a heavy discount in the bond price.
Now introduce to this environment CDS trading. Allowing CDS contracts attracts into the credit market investors who want to short the underlying bonds by buying CDS—that is, naked CDS buyers. In response, long investors also enter the market seeking to be on the other side and sell CDS to naked CDS buyers. Because these CDS trades do not require trading the underlying bond, the volume of such CDS trades and the investors' decision to participate in these trades are not limited by the availability of bonds. Importantly, for long investors, selling CDS versus buying bonds are economically similar trades (they both pay off if the bond issuer does not default). Thus, as a by-product, determining the prices at which investors are willing to sell CDS also determines prices at which they are willing to buy the bonds. So long investors also start looking for bonds to buy as they look for CDS trading opportunities. The end effect is more bond trading activity and an increase in the value of the bonds. Thus, the introduction of CDS indexed to the bond cash flow restores bond market liquidity and bond prices.
These results challenge the conventional theory that long investors instead of buying bonds would just sell CDS to naked CDS buyers and thereby reduce the demand for the bond. That is, bond sellers now compete with naked CDS buyers for the same set of counterparties. But this way of thinking assumes that the total number of long investors participating in the credit market remains constant after CDS introduction. As my research shows, their number instead increases in response to the emergence of naked CDS buyers. In the above example, the long investors who enter the credit market and, in turn, revive bond trading initially enter because of naked CDS buyers.
I also show that CDS purchases for the purpose of actually hedging bonds that one owns (i.e., covered CDS purchases) do not have the same positive effects on the underlying bonds. Such CDS purchases reduce the bond trading volume and have no effect on the bond price.
An implication of this analysis is that banning naked CDS purchases reverses the positive effects of speculative CDS trades. Following a ban, long investors can no longer sell CDS because their counterparties are banned from buying CDS. Long investors exit the CDS market, but by exiting the CDS market, they also pull out from the bond market. The result is a decrease in bond market liquidity and bond prices.
Thus, naked CDS bans had the opposite effect from the ones politicians intended: they increased sovereigns' borrowing costs and thereby exacerbated the sovereign debt crisis.
[1] CBS, 60 Minutes, “The Bet That Blew Up Wall Street,” October 26, 2008, https://www.cbsnews.com/news/the-bet-that-blew-up-wall-street/.
[2] Bank for International Settlements, “BIS Quarterly Review: The credit default swap market: What a difference a decade makes,” June 2018.
[3] Bank for International Settlements, “Global OTC derivatives market,” Table D5.1, May 2022.
Associate Research Scholar and Lecturer
Bendheim Center of Finance. Princeton University