Naked Credit Default Swaps: Exposed!

The term "naked CDS (Credit Default Swap)" has been tossed around a lot lately, with little to no examination of the etymology of the term. You may have heard of "naked short selling" of stock, and a bit of Google action will tell you that naked short selling is generally illegal. So, you'd be inclined to think that naked CDS must be similar in nature to naked short selling, and inevitably conclude that naked CDS would be illegal but for Wall Street's tentacles. But of course, you'd be wrong.

Naked Short Selling

Naked short selling has nothing to do with being a hedonistic financier. Ordinarily, to short sell a stock, you (i) borrow the stock and then (ii) sell it to someone else. This pair of transactions leaves you with an amount of cash equal to the price of the stock at the time of the sale and an obligation to the deliver stock to the lender at some time in the future. If the price of the stock drops after the sale, you can purchase the stock in the market for less than the price you sold it for, deliver the stock to the lender, and pocket the difference. Fantastic. Naked short selling is very similar, except you never actually borrow the stock. That's right, you sell something you don't actually own. There are circumstances where this wouldn't be much of a problem (e.g., I don't own the stock right now but I will in the next couple of minutes) and we might want to allow the practice to occur. But exactly when the practice is acceptable is beyond the scope of this discussion. The key point is that naked short selling involves the sale of an asset you do not currently own.

Naked CDS

A naked CDS position is a short position that is unhedged by the underlying credit risk. For example, I have a short position on a bond through a CDS but I don't actually own the bond. This means that I profit if the price of CDS protection on the bond increases, which usually means that the underlying bond is more likely to default than when I opened up the CDS trade. Note that I have not sold anything that I don't own. The equivocation between naked CDS and naked short selling stems from the observation that in each case, you don't own the thing in question. Sure, but in the case of a naked CDS position, you're not trying to sell the thing you don't own.  It is the sale without current ownership that makes naked short selling problematic in certain contexts. In contrast, in the case of a naked CDS position, you simply enter into a trade expressing a negative view on a credit, that is all.

Naked CDS positions are similar to unhedged puts: buying a put on a stock without actually owning the stock. A put gives you the right to exchange stock for a fixed amount of cash, called the strike price. If the market price goes below strike price, you can go and buy the stock from the market, exercise the put, and pocket the difference between the strike price and the market price. Fantastic. So the more the price of the stock falls, the more you profit. How evil. Of course, no one has a problem with unhedged puts, even though they express a negative view on an asset in almost the same way a naked CDS position does. But don't forget, puts are not part of the "shadow banking system," or whatever other garbage meme is being pumped this week.

Same Same But Different

Pundits also grumble because naked CDS positions are speculative, as are short positions on commodities, such as the price of fuel. But of course, the custom crafted pundit logic applies differently to different markets. For example, in the context of CDS, naked CDS speculators are bad because they magically cause the price of the underlying bond to decrease. But when it comes to commodities, pundits claim that speculators cause the price of the underlying commodity to increase. They hold this to be true despite the fact that both the CDS market and the futures markets are comprised of an equal number of long and short positions, by definition. Moreover, speculators can make money on both the long and the short end of a trade in either market, so why should we assume they consistently choose the "evil side" of the trade? Why markets with such similar characteristics yield such different criticisms is beyond me, but perhaps one day I too will wield the Möbius strip of pundit logic.