The Naked Civil Servant

The impact of unilateral action by the German financial regulator BaFin on various trading activities is reasonably clear. What is less so is the motivation and, by extension, the level of understanding of how financial markets operate.

My own position on the corporate credit default swaps (CDS) market has always been one of skepticism as to its full value and transparency. However there are circumstances in which CDS - a risk transfer mechanism – can be a useful tool for those who have a credit or credit-like exposure to an issuer even though they don't own the security referenced by the CDS (by definition, ‘naked’). A company can buy CDS to help manage exposure to customers (other companies or governments and so on) whose financial distress would damage the company. There is no doubt a basis risk between the triggering "credit events" in the CDS and the company’s exposure, but for a company seeking catastrophe protection that may not be the point. A financial services firm selling a CDS to a company may itself then want to buy protection from others as it adjusts its exposures. In seeking to discourage "naked" CDS purchase, care is needed in definitions not to shut out those with credit-like exposures for which CDS represent one of the few financial routes to risk mitigation. And this, for me, is where the markets diverge from political expediency.

CDS and derivatives in general have become the whipping-boys for all the excesses and problems in financial and credit markets. But let’s be clear: sovereign governments and not ‘speculators’ make decisions about tax-and-spend. The price of debt (and broadly a CDS) incurred as a result of a fundamental imbalance in a national economy won’t change even if there was no ‘trading’ at all. People would find somewhere else to invest their cash, usually a different currency in a different country but crucially one on which they can (or believe they can) rely. A ‘one size fits all’ currency bloc makes life difficult for all its participants. Tough, but don’t blame the markets.

By Peter Matza