Recently as the Greek sovereign debt crisis continues to unravel, numerous groups have pleaded for regulatory bodies to restrict or outright ban naked Credit Default Swaps. It has been argued by the Greek Prime Minister, that the use of these financial instruments have amplified the volatility currently characterising debt markets:
“We should not allow speculators to play around with the stability of the Eurozone”
(Sourced – H. Pulizzi from The Times, 11th March 2010)
To the non-financially educated, the three functional purposes for the existence of derivatives are:
1. Hedging is used to reduce or neutralise the exposure to the underlying asset or another risk.
2. Arbitraging discrepancies in pricing between markets or assets, thus keeping prices efficient.
3. Speculating on positions or views on the future of an instrument or market.
The United States' Affordable Housing Institute provides the defination of a CDS below.
(Sourced from AHI, Google images)
None of the above is more so important than speculating - naked positions – in adding liquidity to the market, being the foundation on which any effective financial market is built on. Investing in itself is a form of speculating, and without investment, capital markets would cease to function.
The involvement of speculators in any financial market significantly increases the financial depth and breadth for both buyers and sellers, allowing participants who need to hedge an exposure (hedgers) with significant more of a market to sell or buy to – therefore inducing further competition – and allowing these participants to attract better pricing. They are also paramount in the role of capital allocation, providing it for growth and withdrawing it from non-profitable avenues. As stated by Paul Murply from The Times: -“Speculators do God’s work”.
Contrary to the belief of the Greek Prime Minister, and numerous political groups, the CDS market, which constitutes only 2% of the outstanding Greek debt, does not have the power to push counties towards default. They are merely a tool for market participants to hedge or speculate. The Bond holders that invested ~€5 billion in the recent debt raising by the Greek Government, are far more educated the debt investing than to be concerned by the CDS market.
The fundamental issue is that ostracising the CDS market is a notion by political groups purely to impress or rally public support from the public. As Paul Murphy from the Financial Times outlined on the 14th of March, employees of the Greek government currently facing austerity measures, rightly would direct anger at any scapegoat seen to be associated with the pain.
The use of financial-buzz-words to stir-public anger and avert political scrutiny is no new concept, only weeks ago we observed the peak of the ignorance of political and media groups seeking to curb executive remuneration. These companies exist with the funding or their shareholders, not of the general public. If an individual believes that the executive remuneration in a company is excessive, he can simply cease to be a shareholder in that company. Albeit institutions that have received taxpayer funds to continue operations, should be governed by its shareholders – i.e. the taxpayer.
A derivative’s value, by definition, is an instrument whose value is based on another source. The CDS market is not the source of the problem facing the Greek economy. Greece is the source, struggling with serious concerns over its viability to refinance and tame the soaring budget deficit.
Politicians should focus on the source of problems, rather than seeking to divert the non-financially educated public’s scrutiny to financial derivatives.
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