Credit default swaps don't kill countries and companies; bad management kills countries and companies.
Yet credit default swaps - derivatives that allow traders to bet on the health of bond-issuing companies and countries - are once again in the news as the culprits in the potential downfall of Greece.
The argument holds that speculators and hedge funds are pushing around credit default swaps (CDSs), a relatively illiquid market, to foment fear that Greece will default. This, critics say, is making it harder for Greece to raise money and that's going to increase the odds of default. It's a bond market death spiral.
Suddenly, there are headlines in Greek and Spanish papers about secret service operatives from the nations' spy agencies using James Bond-worthy techniques to try to find out who's messing with the countries' bonds.
CDSs also killed American International Group, if the headlines following its $85-billion bailout by the U.S. government are to be believed. More realistically, AIG tried to kill itself in a spectacular act of self-immolation, owing to brutally bad management. The simple fact was the company wrote a bunch of insurance policies it couldn't cover, and CDSs were simply the form of insurance. If AIG had mismanaged a life insurance portfolio and ended up requiring a bailout, nobody would be demanding the end of life insurance.
Yet, because we're talking about derivatives such as credit default swaps, instruments that are supposedly complicated (they're not), it's easy to shift the blame from the real bad actors to the tools. Credit default swaps do sound arcane and evil, but they're just insurance contracts. Few things are more boring and quotidian than insurance.
Consider the stock market equivalent to the CDS situation in Greece: a plunge in shares started by concern about a company's health. Few would blame investors for selling shares, or for buying insurance protection against a drop in the form of put options, even though the sliding stock price and suspicious options activity would make it tougher and tougher for the company to raise money to stay alive.
Sure, there are times when short sellers cook up a bogus story to make a stock tank, but Greece really is in trouble. The only people making up numbers about the health of the Greek government's finances seem to be those in the Greek government.
So why the fear and distrust in CDS land, while stock markets blithely trash companies every day? Transparency. The stock market has it, enabling investors and regulators to get a decent picture of what's going on. The CDS world doesn't.
Stock exchanges publish lists of who's trading what stocks and tallies of how much stock has been sold short. Investors can see in real time what's going on. Regulators can often see much more. This is possible because stocks trade in central markets with strict reporting requirements. Stock trades are also cleared through central systems called clearinghouses, creating another layer of transparency and record keeping. The same is true of stock options (which are derivatives, too). No 007-style high jinks are required to find out what's really going on.
Because stocks are listed on exchanges, those exchanges can have strict disclosure requirements that demand investors be told anything they might need to know.
Bond and derivative markets offer little if any of this. Most derivatives are traded in secret between two parties, whether banks or hedge funds or companies or traditional mutual funds. Derivatives and bonds are often traded with no prospectus, which means regulators don't much care what's going on. What happens in the fixed-income market stays in the fixed-income market.
Changing that culture of secrecy is proving hard, especially in North America. And oddly, it's not always because of the brokers, the traditional opponents of openness because it can cut into their profits. In the case of CDSs, it's the investors.
Europe has required brokers to use central clearinghouses for CDSs since 2009, and the U.S. Federal Reserve Board has brokerages in the United States on side with clearing trades centrally as well.
But investors such as Pacific Investment Management Co. (Pimco) are reportedly balking, arguing they don't see benefits that justify the cost of regulation, which their investors ultimately would have to pay.
While they support the idea in principle, they say their duty is to get the best performance for unitholders. That means minimizing costs.
This is something that regulators are going to have to resolve, and fast.
Whatever happens in the United States and Europe on credit default swaps and other derivatives is likely to dictate what happens in Canada.
The Bank of Canada and the investment industry are working to get some over-the-counter fixed-income transactions processed through a central clearinghouse, but have stopped short of trying to get derivatives cleared here in Canada. That's because, the industry argues, derivatives are generally traded across borders and Canada is a small player.
Trading of bonds is also tough to see in Canada because of a lack of transparency.
Regulators, led by the Investment Industry Regulatory Organization of Canada, recognize the need for change but have been slow to require it.
When people can't see what's going on, they assume the worst, and that's not good for markets.