Should We Cheer the Credit Default Swap Market's Decline?

There were few scapegoats for the financial crisis exploited quite as aggressively as credit default swaps (CDS). Although the derivative instruments played a major part in AIG's problems, no one has managed to prove that they are intrinsically harmful. After all, CDS should create a more efficient market by serving as insurance to hedge debt and by providing investors with quickly accessible market-driven measures of default risk for companies and securities. Yet, the financial regulation bill rein in the CDS market. It appears to have succeeded.

Shannon D. Harrington and Christine Harper of Bloomberg report that the CDS business has plummeted 40% to 60% compared to what it looked like in the pre-financial crisis world. Those skeptical of CDS might shrug off this statistic, or even wish the decline was bigger. After all, if these derivatives really are pure poison as some critics believe, then they won't be missed.

Whether or not we can judge this development as positive or negative depends on the reason for the market's decline. If prudent regulatory requirements are to blame, then that's okay. For example, ensuring that issuers have enough capital to back up the CDS they sell may have resulted in a market correction. Certainly, firms should be forced to have enough collateral set aside to reasonably be able to endure market shocks that could force them to pay up for the insurance-like product they're selling. If the market has shrunk because CDS was underpriced in the past, for example, then the economy is better off now.

But that isn't the only potential explanation for why we're seeing less CDS. In the Bloomberg article mentioned above, Sanford C. Bernstein & Co. analyst Brad Hintz explains another possibility:

Congress considered banning investors from buying swaps if they didn't own the underlying debt they were insuring. Though that proposal died, the threat contributed to the slowdown in trading. Would-be users of the derivatives are staying out of the market until they determine how stringent the final rules will be once regulators impose them next year, Hintz said.

"No one's going to enter into a credit-default swap when you don't know what the rules are going to be going forward," Hintz said.

So regulatory uncertainty may be causing fewer investors to buy CDS as a way to bet against a company or security. If that's the reason for a major portion of the market's decline, then that's bad. It would indicate that the market has become less efficient. CDS serves as a way to better understand the market's view of the health of a company or security. If investors are no longer investing in naked CDS as a way to short bonds and firms, then the market will be left with an overly optimistic view of companies or securities that could be in trouble.

(For some additional posts on why a CDS market is a good thing, see here and here.)