Reframing Credit Default Swaps (CDSs) as Quasi-Insurance
Posted: 14 Aug 2014
Date Written: August 12, 2014
Abstract
Credit default swaps (CDSs) played a major role in the Global Financial Crisis (GFC). CDSs coupled with Collateralised Debt Obligations (CDOs) and other asset-backed financial products were heavily traded in the years preceding the GFC. Intended for sophisticated investors, CDSs are in the nature of insurance contracts, although they operate outside the scope of the legislation and regulation governing insurance. Thus, for example, the insurance law concepts of insurable interest and indemnity do not apply to CDSs under current CDS regulation, insofar as it exists. In the absence of these concepts, CDSs become rather a bet about the prospects of a third party borrower’s default where the protection buyer has no direct economic exposure to the financial asset underlying the CDS. In the case of a default, the CDS provider must pay on the bet (i.e. provide compensation) to potentially many parties. If the risk of default is crystallised, this could hamper a protection seller such as AIG. Before the GFC, AIG stated it was 99.85% certain that no credit event could take place for the CDSs they had written. Unhappily for AIG, their 0.15% probability estimate crystallised, triggering $9.5 billion in losses for AIG alone. One solution to AIG's dilemma (and that of similar providers) in the GFC would have been to regulate CDSs as if they were a form of insurance, rather than a bet simpliciter. For example, like insured parties in general insurance arrangements, the bank as CDS beneficiary could be required to pay an “excess” on any credit default events under the CDS. Secondly, CDS providers – or perhaps CDS regulation – could require CDS buyers to have insurable interest in the underlying financial assets (e.g. bonds) in order to enter into a CDS. Such a reform of CDS praxis would obviate the indemnity problems inherent in current CDS arrangements.
Keywords: CDS, Securitization, GFC
JEL Classification: K00
Suggested Citation: Suggested Citation