When you lend money to somebody, you bear a certain amount of risk that he won’t pay you back. In exchange, you earn interest. But maybe you’d like to bear a bit less risk and earn a slightly lower rate of return. You could just find someone else to lend money to, but there may not be demand for loans at exactly the risk/return point you’re looking for. Another alternative would be to hedge your risks through insurance. That’s the origin of the “credit default swap” concept, you take a position that pays off in the case of default. Then as with all other kinds of financial instruments, a secondary market develops and soon enough you have a whole different business in writing and trading CDS contracts alongside bonds.
But a funny thing happened on the way to the partial Greek default in late October. European leaders proclaimed that banks were going to take a 50 percent haircut “voluntarily” even though the whole point of politicians getting together to make the deal was to underscore the non-voluntary nature of the restructuring. It was declared voluntary, however, precisely in order to protect institutions with CDS exposure. As a result of this, market participants no longer have confidence that sovereign credit default swaps mean what they’re supposed to mean, and the correlation of CDS rates to yields is plummeting.
Should we care? On the face of it: meh. But there’s a catch. The Council on Foreign Relations predicts that “the market is unlikely to die owing to Basel III bank capital regulations,” which allow banks to use CDS contracts to offset certain forms of risk. Consequently, even if these instruments have no value as ways to actually hedge risk, they will retain some value as instruments to create the appearance of reduced risk for regulatory purposes. The availability of these kind of regulatory arbitrage plays is a vulnerability in any scheme of financial regulation, but the speed with which this possibility has emerged should disturb us. The specific problem is important, but this is also a reminder that “principles-based” financial regulatory frameworks are likely to work out better than “rules-based” ones over the long run.