Credit Default Swaps and Greece

Credit Default Swaps (CDS) are funny financial instruments. They are similar to an insurance policy intended to protect a creditor or bond holder from the risk of default by the debtor or bond issuer. All in all a very wise precaution if you are extending credit in the form of purchasing bonds from countries or companies.

 Where CDSs depart from insurance is that you can take out this insurance to protect a debt default on a debt for which you have no liability, this is similar to taking out an insurance policy on your neighbour's house because you think that his fire precautions are  bit slack and his house is likely to burn down. A very weird concept indeed. Another twist to the CDS trade is that the instruments are also tradable and can be bought or sold in an "Over the Counter" market.

 Your natural instinct in this situation is to profess this market to be crazy and allowing someone to buy insurance against a debt default for which they have no direct liability cannot be a good thing. This is the argument being put forward currently by the EU in respect to Greece. There has been considerable speculation in the CDS market on Greek bonds as the markets feel that a default by Greece is a reasonably likely outcome and they are willing to stump up the premiums required to benefit should such a default occur.

 The EU want to restrict the capability, particularly of Hedge Funds, to speculate about a Greek Default via the use of CDS instruments. I didagree with this position. The reason that Greece is in its current fiscal position is due to financial mismanagement and political weakness. The speculation by the markets whilst it will pile additional pressure on the EU and the Greeks, will also force them into addressing the fundamental problems in the Euro zone which are needed to prevent the Greek issue spreading to Italy, Spain, Portugal ,Ireland etc.

 The Hedge Funds involved isn this trade stand to make a lot of money should there be a default but also to lose a lot of money should that not happen. That is the natgure of the free market. Attempting to place artificial restrictions on trade, as was done with the short selling ban on bank shares last year, is counter-productive. CDS markets and short selling do not drive events, they react to events. The outcome of events is in the hands of politicians and it does no harms to have a bit of financial pressure to make them "do the right thing".