Stephen Foley: Vast and dangerous CDS market threatens new financial panics

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The Independent Online

US Outlook: You don't know me; we've never met. But how would you feel if I told you I had taken out a life insurance policy on your life? Would you feel a little nervous? Don't worry, I haven't actually done it. (I wouldn't know where to hire an assassin either, by the way.) In fact, taking out insurance on other people's lives is a practice that is banned, for obvious reasons.

You will be unsurprised to learn that the same commonsense principle does not exist in financial markets. And if this week's speech by the derivatives market's chief regulator, Gary Gensler of the CFTC, is anything to go by, it isn't likely to be applied where it is most urgently needed, namely in the $25 trillion market for credit default swaps.

CDS were designed as insurance for bond investors, paying out if the original bond issuer – Lehman Brothers, say, or Greece – defaults. But banks can create an unlimited number of CDS insurance policies on any bond, sell them to anyone, regardless of whether they own the bond, and then trade them in the open market. As a result, CDS have become chips for speculating on bond issuers' improving or deteriorating financial health.

I get a "market report" every day telling me about the session's trading in CDS, part of the industry's attempt to pretend these instruments are just another mundane part of the financial markets. It reads for all the world like a report on the FTSE 100, when it might be better presented as the end-of-night accounts of a Las Vegas casino.

Let me say, speculation is not a dirty word. All financial market activity is speculation. But where most – such as in the stock market – helps allocate capital in the economy, the CDS market is different. In its short life it has created numerous distortions. Bond investors who have "over-insured" using CDS have more to gain from pushing a firm into bankruptcy, which is why Mr Gensler was palming the issue off to Congress and suggesting they alter bankruptcy law to reduce the influence of these so-called "empty creditors".

More importantly, the existence of the huge and liquid CDS market vastly increased the financial panic of 2008, and threatened to trigger a new one in eurozone sovereign debt this year, which is why EU leaders this week argued for a ban on CDS for non-insurance (they used the word "speculative") uses.

Mr Gensler seems comfortable with the current proposals to corral the trading of CDS on to regulated exchanges. He's still talking the Wall Street language of "transparency" and "liquidity". George Soros, speculator extraordinaire, is a better voice on this subject. He wants a ban on CDS use by anyone that doesn't have an underlying bond exposure to insure. That's common sense.