Question on CDS

lmimmfn

A quick question on Credit Default Swaps, to me it reads as effectively a gamble against some one/company/country defaulting. However the purchaser of the CDS has no relation to the actual some one/company/country and is effectively gambling on it.

So if my understanding is correct, because these are such large transactions( involving countries ) then technically more money could be gambled on CDS than exists physically in the world?

Maybe thats overly simplistic, but my point/understanding on what it boils down to is the total value of betting on defaults can and is effectively more than the cost of the actual default?

Maybe i have it all wrong, some info would be good, also why arent CDS illegal?

nesf

The thing to remember is that someone loses in a CDS either way. Think of it as buying insurance, there will always be a loser with insurance.

This puts a brake on how many CDS will be out on a particular event. No one will want to be too exposed to a particular credit event and you will eventually run out of counterparties willing to be involved in a CDS.

The other thing is that they serve a very important function in that they allow very easy hedging of positions and can reduce risk exposure in a deal for the lender/owner. This existence makes it more likely for lenders etc to exist in the first place than if it was more difficult or expensive to hedge against a credit event.

lmimmfn

nesf wrote: »

The thing to remember is that someone loses in a CDS either way. Think of it as buying insurance, there will always be a loser with insurance.

This puts a brake on how many CDS will be out on a particular event. No one will want to be too exposed to a particular credit event and you will eventually run out of counterparties willing to be involved in a CDS.

The other thing is that they serve a very important function in that they allow very easy hedging of positions and can reduce risk exposure in a deal for the lender/owner. This existence makes it more likely for lenders etc to exist in the first place than if it was more difficult or expensive to hedge against a credit event.

ok, but because its such large quantities of cash, say for example betting against a Sterling default.
If the number of sterling notes in circulation is 1 trillian what happens if the cumulative value of CDS is 1.5 trillian then where does the money come from and what would happen in that case? or is it limited to the maximum cash in circulation and CDS cant be issued beyond that?

I realise that the payout could be no more than whats in circulation and that someone has to pay but what happens the currency in that circumstance?. Again im probably misunderstanding it but to me it seems to be betting on such a high level that currencies are or will become crippled because of it.

I know there has to be someone backing the bet but wouldnt circumstances exist where they cant pay the bet? and what happens in that event? particularly to the currency involved?

Apologies if the questions seem lame, just trying to understand how exactly they work and the implications when a country defaults. Are there any examples, did Argentina suffer with CDS?

nesf

lmimmfn wrote: »

ok, but because its such large quantities of cash, say for example betting against a Sterling default.
If the number of sterling notes in circulation is 1 trillian what happens if the cumulative value of CDS is 1.5 trillian then where does the money come from and what would happen in that case? or is it limited to the maximum cash in circulation and CDS cant be issued beyond that?

I realise that the payout could be no more than whats in circulation and that someone has to pay but what happens the currency in that circumstance?. Again im probably misunderstanding it but to me it seems to be betting on such a high level that currencies are or will become crippled because of it.

I know there has to be someone backing the bet but wouldnt circumstances exist where they cant pay the bet? and what happens in that event? particularly to the currency involved?

Apologies if the questions seem lame, just trying to understand how exactly they work and the implications when a country defaults. Are there any examples, did Argentina suffer with CDS?

I could be wrong, I'm not hugely read up in this area but if there was a problem with CDSs not being able to be paid then it shouldn't effect the currency overly much, just make things very unpleasant for anyone holding a CDS and who hasn't been paid.

The money for CDSs has to be "in circulation", i.e. if a CDS pays out the insurer has to find the money somewhere to pay it off. This could be in the form of a loan from a bank and this is "new money" but it's regular new money as opposed to unusual new money.

whatstherush

nesf wrote: »

The thing to remember is that someone loses in a CDS either way. Think of it as buying insurance, there will always be a loser with insurance.

I don't think this insurance analogy fits fully. Taking out a CDS on a bond you own to hedge would fit perfectly with your analogy. Taking out a CDS on bond that you don't own, is a pure gamble on the hope the bond will go bad.

SBWife

I think what Nesf is trying to communicate is that in a CDO transaction as in that of any derivative there are two sides and the gain to one side is equal to the loss to the other.

The second issue that people seem to be asking about is counterparty risk. The risk that one side in the derivatives transaction won't be able to pay what it's obligated to pay under the contract. Institutions who trade in OTC derivatives spend a significant amount of time and money monitoring this risk and it's why the writing of these contracts tends to be such a specialised business.

nesf

whatstherush wrote: »

I don't think this insurance analogy fits fully. Taking out a CDS on a bond you own to hedge would fit perfectly with your analogy. Taking out a CDS on bond that you don't own, is a pure gamble on the hope the bond will go bad.

I think the insurance analogy works. It's just like insuring some stranger's house against fire rather than your own. Sure it's a gamble, as in you don't gain anything by the house not going on fire directly but it's still insurance.

Debtocracy

I’d feel very uneasy if my neighbour took out home insurance on my house

CDSs, CDOs and other toxic derivatives are Weapons of Mass Financial Destruction. They are presented as reducing risk but in reality their complexity just leads to huge errors of judgement within the financial sector. They also give banks new ways to engage in unethical and fraudulent behaviour.

Given the control that major banks have on society (as society now depends on bank credit), there are huge ethical problems when a bank benefits by a certain section of the economy failing.

nesf

Debtocracy wrote: »

I’d feel very uneasy if my neighbour took out home insurance on my house

CDSs, CDOs and other toxic derivatives are Weapons of Mass Financial Destruction. They are presented as reducing risk but in reality their complexity just leads to huge errors of judgement within the financial sector. They also give banks new ways to engage in unethical and fraudulent behaviour.

Given the control that major banks have on society (as society now depends on bank credit), there are huge ethical problems when a bank benefits by a certain section of the economy failing.

You're starting to get a little soapboxey coming onto every thread with basically the same rant. Please try to contribute a bit more to the forum than your anti-capitalist postings. Note: I am not saying you're not allowed to post anti-capitalist material on here but only contributing it is not adding much to the forum.

hmmm

CDS, like most things in finance, are very useful for commerce and are also open to abuse. The value of naked CDS (i.e. owning a CDS without owning the underlying bonds) is hotly debated.

I may be straying into conspiracy forum stuff, but I'm convinced that the CDS market is being abused by some social media savvy hedgefunds. I've noticed concentrated efforts to create runs against banks, or countries over the past few years - probably as very smart financial people realised the power of the web to whip up hysteria in 2007. Paying a PR company a few tens of thousands to create some blogs and some forum posters is a cheap way to get a run going, from which a hedgefund could make tens (or hundreds) of millions.