Yesterday's Wall Street Journal featured a lengthy piece on swaps regulations. With the recent Greek bond problems as a context, European regulators want to ban dealing in naked swaps, i.e., trading/holding swaps when one does not hold the underlying instrument on which the (risk of default) swap is written.
I had a long conversation with a colleague about this yesterday over lunch.
Why, I asked, is there a presumption of pressure on the interest rate and value of the underlying instrument from naked dealings in a side bet which is the default swap on the instrument?
Swaps are not options. They are simply insurance against default.
If there is any basis for disliking their naked trading, it would seem to be more akin to the aversion regulators have for people purchasing life insurance on third parties in whom they are disinterested. It's become a hot field lately, with investors picking up life insurance policies for the aged, in exchange for paying the premiums.
Our society has had moral reservations against bets on death of this sort for a long time.
As my colleague pointed out, nobody would probably mind if you could bet on a bond's performing as promised. It's the bet on failure that seems to arouse angst and emotion.
Yet, in the case of Greek bonds, it's hard to see how an unrelated, naked derivative position would or could possibly affect the bonds' values as much as the simple trading in the bonds themselves, isn't it?
It's understandable how heavy pressure on an equity's price from options or shorting can occur. Shorts have obvious affect by causing selling pressure, driving equity prices down. Lopsided options activity can create arbitrage opportunities which affect equity prices, too.
But simply executing a parallel bet on an event by buying, or selling, a credit default swap, wouldn't seem to do more than, as today's Journal piece on the topic notes, provide a sentiment indicator. Since the swap confers no rights to buy or sell the underlying bond, it simply can't have an influence on the bond's price beyond that of trading activity in the actual debt instrument.
The entire discussion topic seems, to me, to be one sparked by hysteria, emotion and faulty logic, rather than a genuine, proven causal effect between swaps prices and the price of the underlying debt instrument.
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8 comments:
the concern over swaps is that the big banks are using them to make bets without adequate reserves, and if they go under, the taxpayer will be forced to bail them out. At least if the big banks make bets on exchange traded instruments or regulated insurance, they have to post margins or reserves. There ain't nothing like that for derivatives. In fact, they do funky transactions using derivatives at quarter end to hide leverage, or at least they used to, as you can see in the examiners' report on Lehman.
I generally see derivatives used because there is an arbitrage due to regulators or tax authorities failing to have comparable restrictions on derivatives, such as no withholding tax on swap payments intended to synthesize dividends, no securities reporting on synthetic equity positions built up using equity swaps, poor reporting of positions in derivatives (allowing people to have off the books leverage hidden from shareholders and creditors), not recognizing taxable gains on disposing of assets due to tax authorities not really understanding equity and credit derivatives. I can go on.
Thanks for your comment.
I understand the thrust of your remarks. However, I have to say that I have not seen such an explicit reference to the concern you describe.
Plus, what about the myriad privately-held hedge funds and private equity groups doing the same thing?
Further, don't the recent ISDA-mandated daily settlement of swaps value changes pretty much mitigate such large-scale, unexpected defaults on payments?
There may be tax-based reasons for using swaps.
But my central question remains, at least for me. On what evidence do regulators worry that derivative volumes will distort a situation in which there are functioning markets for the primary instruments?
-CN
Mr. Neul: But my central question remains, at least for me. On what evidence do regulators worry that derivative volumes will distort a situation in which there are functioning markets for the primary instruments?
The regulators worry because CDS are thinly traded, markets react to them stupidly as if the prices reflect underlying value, and hedge fund managers have been fingered at attempting to use them to manipulate stock prices by building a large short position in the equity of a company and then buying a small position in the company's debt to spook the equities market and thereby make money on the larger equity short position.
I have read public statements by fund managers asserting that people are doing this. I couldn't say if it is true. And given the lack of regulation on CDS, I doubt the regulators can say whether this is happening. In any event, we need regulation to prevent people from using CDS to manipulate publicly traded markets.
And bigger picture, derivatives were really a way for people to make money by avoiding regulations, in particular rules regarding margin requirements for exchange traded instruments, capital requirements for on-balance loans, and reserve requirements for insurance. This allowed firms to increase their leverage beyond where they could if derivatives were subject to the same rules as loans, exchange traded instruments, and insurance. Derivatives were secondarily used for avoiding taxes and securities regulations.
Some examples:
Schering Plough's use of swaps to avoid taxes, which was held invalid by a court:
http://www.bakermckenzie.com/RRUSTaxAuthoritiesScrutinizeStructuredTransationsOct09/
The Children's Investment Fund's use of swaps to avoid 13D securities filing rules, which was held invalid by a court: http://www1.nysd.uscourts.gov/cases/show.php?db=special&id=79
I rarely see a business purpose for using derivatives beyond avoiding banking, securities, or tax law. But I don't see everything. It is an empirical question whether derivatives are mostly used for tax and regulatory arbitrage.
Oh and one other thing, the additional risk with equity or credit swaps that are naked is that one needs regulations to deal with a separation of the voting rights built into the underlying instrument. Otherwise, one can end up with a holder of equity or debt using voting rights (debt has voting rights to call a default and to veto a bankruptcy plan of reorganization), so the holder of the underlying can vote for perverse reasons. This is particularly problematic if a creditor holds a position just large enough to veto workouts or bankruptcy restructurings, in order to collect a pay out on a much larger position in the CDS.
Mr Neul: Plus, what about the myriad privately-held hedge funds and private equity groups doing the same thing?
Participation of unregulated entities is essential to regulatory arbitrages intended to avoid capital, reserve, or margin requirements. Effectively, the regulated brokers, banks, and insurance companies engage in derivatives transactions with unregulated entities to shift risk to unrelated entities that don't face the same margin, capital or reserve requirements. The profit lies in the fact that the arrangement allows the parties as a whole to hold less capital than the regulators would require if both counterparties were regulated.
Sorry for breaking my points into separate comments.
All very nice, but very misleading.
First, countries don't have equity. So equating CDOs on Greek debt is not the same as alleging using options- which are NOT CDOs, as I have pointedo out- to pressure equities. As to buying corporate debt to affect equity prices, if it's a small amount, it won't.
I totally disagree with your contention that the major reason anyone uses options is to circumvent leverage or tax regulations.
That's simply wrong. Options are an efficient way of taking positions on securities with liquid markets.
-CN
Again, interesting if we were discussing corporates.
I wrote about sovereign debt.
So, your points are basically moot.
Nice try, though.
-CN
Re unregulated, private entities, your point is?
You have a latent belief that somehow all things need 'regulation,' rather than simply acknowledging that market forces will find their way to affect prices.
How a regulated entity can "shift risk to unrelated entities" in some useful way because it's unregulated is beyond me.
I don't control the other side of my option transaction. You can't even be sure a regulated entity knows who is on the other side of every derivatives trade.
So, again, your point is moot.
And denies the reality that private firms have the right to use their unregulated status to be limited only by their lenders.
Why is that wrong? If their lenders are satisfied with the capital adequacy, who are you to declare they must be regulated?
In my opinion, you represent the entirely naive, myopic and wrong-headed view that with just more regulations, securities markets can be made "safe."
In reality, the situation is much more like that described by Lt. Spears in Band of Brothers to the private in his foxhole outside of Carentan. That is, the private's mistake was believing there was hope of surviving combat. Once he abandoned that, Spears counseled, then the soldier could fight without worry, and "all combat depends upon that."
Similarly, all markets depend, ultimately, upon each buyer and seller individually being responsible for risk assessment and risk assumption. Relying on, then blaming, third parties, especially regulators, is just more Nanny-Statism in disguise.
WHine....whine....whine.....rather than do one's own investing homework and taking one's losses as appropriate.
-CN
-CN
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