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The CDS Myth

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Four common sales pitches and how to refute them.

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A number of major benefits of CDS contracts are often cited by acolytes and fans - particularly by those promoting the product.

Claim 1: CDS contracts help complete markets.

They do this, runs the argument, by enhancing investment and borrowing opportunities, reducing transaction costs, and allowing risk transfer. CDS contracts, when used for hedging, do offer these advantages. When not used for hedging, it's not clear how they help in capital formation or in enhancing market efficiency.

Claim 2: CDS contracts improve market liquidity.

The reason: Speculative interest assists in enhancing liquidity and lowering trading costs. If the liquidity comes from leveraged investors, the additional systemic risk from the activity of these entities has to be balanced against potential benefits. The current financial crisis highlights these tradeoffs.

Claim 3: CDS contracts improve the efficiency of credit pricing.

It's unclear whether this is actually the case in practice. Pricing of CDS contracts frequently doesn't accord with reasonable expected risk of default. The CDS prices, in practice, incorporate substantial liquidity premiums, compensation for volatility of credit spreads, and other factors.

CDS pricing also frequently doesn't align with pricing of other traded credit instruments, such as bonds or loans. For example, the existence of the "negative basis trade" is predicated on pricing inefficiency.

In a negative basis transaction, commonly undertaken by investors (including insurance companies), the investor purchases a bond issued by the reference entity and hedges the credit risk by buying protection on the issuer using a CDS contract. The transaction is designed to lock in a positive margin between the earnings on the bond and CDS fees. Negative basis trades exploit market inefficiencies in the pricing of credit risk between bond and CDS markets.

In early 2009, the pricing of corporate bonds and CDS on the issuer diverged significantly. For example, the CDS fees for National Grid (NCG), a UK utility, were around 2.00% pa (200 basis points) compared to National Grid's credit spread to government of around 3.30% (330 basis points). Similarly, Tesco (TESO) the UK retailer was exhibited CDS fees of around 1.40% (140 basis points) against a credit spread to government of around 2.50% (250 basis points).

In effect, market pricing of credit risk as between the CDS market and the bond and loan market, was significantly different.

Another area of pricing discrepancy is the relative pricing of different firms. For example, in early 2009, bonds issued by borrowers rated "A" were trading at a higher credit spread than bonds of borrowers rated lower (say "B") in the bond market. At the same times, CDS fees for borrowers rated "A" were trading at a lower level than CDS fees of borrowers rated lower (say "B") in the credit derivatives market.
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