3 ms·

Yes, I am referring to CDSs. Insurance contracts are always derivatives at their core. But insurance is regulated more tightly than general derivatives partly

Yes, I am referring to CDSs. Insurance contracts are always derivatives at their core. But insurance is regulated more tightly than general derivatives partly for historic reasons, and partly because the specific nature of insurance can be regulated more effectively and easily than the general nature of derivatives. One example of this is that you cannot insure something for more than it is worth (well, you can, but the insurers liability is limited to the actual cost of the loss). But you can amass a huge CDS position with no exposure at all to the underlying asset. If these instruments are just insurance against the underlying defaulting then that should not be permitted. If they're being used to speculate, that is fine, but then banks issuing them need to be upfront and say that they too are speculating. And whether we want strategically important, government backed organisations speculating is the question. Also, forgive my ignorance: Doesn't only the issuer of a CDS need to post collateral? Unless the buyer is buying it on margin?

swedishturnip 4y ago
Some participants speculate, others hedge an actual risk, yet others “reinsure” the risk (in insurance terms) to earn a premium - there are all kinds. And yes it would be quite rare for a CDS not to be traded under a collateral agreement - in fact most these days are cleared (and as the case may be, netted) with a central counterparty to minimize a web of counterparty risk that might otherwise be problematic.
credit_guy 4y ago
1. Insurability. In insurance, the typical fraud is to overinsure something and then destroy it. You can do that because you are destroying your property. Nobody is trying to insure against the loss of the neighbor's house, and then go an burn it, because they commit both insurance fraud and a crime against the neighbor, the latter being punished much more severely. Similarly, I could try to buy CDS to protect against Tesla default, and then go and dynamite one Gigafactory and hope that Tesla does default, and I make a lot of money. But the law enforcement deterrence against that is huge. And if you are the type of criminal willing to break the law to such an extent, then there are simpler ways to make money. You could for example short the Tesla stock, or buy puts. Or you can just go and kidnap Musk, your sentence when you are caught will probably be lower. 2. Speculation. That's a loaded word. If you buy a bond issued by General Motors, is that speculation? You collect the coupon from GM, and you implicitly are placing a bet that GM will not default. Your action is helping GM invest in their newest assembly line. If you buy their stock, are you speculating? You are placing a similar bet, that GM will do quite well, and the stock will go up. Your action does not directly help GM (the money goes to the seller of the stock which is generally not GM), but it helps indirectly, by lowering GM's cost of funding. When you sell insurance against GM's default, you are placing a similar bet that GM will do well. This too reduces GM's cost of funding (because it reduces their credit spread, which makes it easier for bond holders to hedge their exposure, and so to buy more bonds). I would say (and everyone else would say too) that selling CDS insurance is the opposite of speculation. And by the way, in most cases it's hedge fund that sell this protection, not banks. Banks are just middlemen, they like to be "flat" risk. They buy about as much protection as they sell. 3. Buying CDS on margin. CDS is a swap, you buy on margin by definition. Both buyers and sellers of protection post collateral. Variation Margin is posted by only one (the party that is "out of the money"), and Initial Margin is posted by both.

swedishturnip 4y ago

Some participants speculate, others hedge an actual risk, yet others “reinsure” the risk (in insurance terms) to earn a premium - there are all kinds. And yes it would be quite rare for a CDS not to be traded under a collateral agreement - in fact most these days are cleared (and as the case may be, netted) with a central counterparty to minimize a web of counterparty risk that might otherwise be problematic.

credit_guy 4y ago

1. Insurability. In insurance, the typical fraud is to overinsure something and then destroy it. You can do that because you are destroying your property. Nobody is trying to insure against the loss of the neighbor's house, and then go an burn it, because they commit both insurance fraud and a crime against the neighbor, the latter being punished much more severely. Similarly, I could try to buy CDS to protect against Tesla default, and then go and dynamite one Gigafactory and hope that Tesla does default, and I make a lot of money. But the law enforcement deterrence against that is huge. And if you are the type of criminal willing to break the law to such an extent, then there are simpler ways to make money. You could for example short the Tesla stock, or buy puts. Or you can just go and kidnap Musk, your sentence when you are caught will probably be lower. 2. Speculation. That's a loaded word. If you buy a bond issued by General Motors, is that speculation? You collect the coupon from GM, and you implicitly are placing a bet that GM will not default. Your action is helping GM invest in their newest assembly line. If you buy their stock, are you speculating? You are placing a similar bet, that GM will do quite well, and the stock will go up. Your action does not directly help GM (the money goes to the seller of the stock which is generally not GM), but it helps indirectly, by lowering GM's cost of funding. When you sell insurance against GM's default, you are placing a similar bet that GM will do well. This too reduces GM's cost of funding (because it reduces their credit spread, which makes it easier for bond holders to hedge their exposure, and so to buy more bonds). I would say (and everyone else would say too) that selling CDS insurance is the opposite of speculation. And by the way, in most cases it's hedge fund that sell this protection, not banks. Banks are just middlemen, they like to be "flat" risk. They buy about as much protection as they sell. 3. Buying CDS on margin. CDS is a swap, you buy on margin by definition. Both buyers and sellers of protection post collateral. Variation Margin is posted by only one (the party that is "out of the money"), and Initial Margin is posted by both.