There is a huge debate (at least being portrayed by the media) about what to do with Credit Default Swaps (CDSs), the pesky financial instruments that made AIG and others impotent, and have forced the US to put insolvent firms through anything but conventional bankruptcy. Since the US has put themselves on the hook to these firms, and to the firms that would stand to lose in swap payouts, they are taking the far cheaper bailout route.
Lately, many are calling for the banning of CDSs, and just as many are identifying them as a vital hedging tool. Since most people never look under the first layer of the financial onion, they come off as a tool of the insincere. Like short selling, it is “not nice” to bet on failure, so their purpose is not understood. However, the complete removal of CDS offerings would make investors much less likely to take on large corporate debt positions, hurting the bond and loan industries. In a sense, the existence of CDSs allows capital markets to be more “open”, a politically and economically important part of our current national agenda.
It seems to me that the obvious solution is also a relatively simple one. Make CDSs incredibly boring. Savings account boring. Regulate the market until nothing exciting can be done. Require dealers to be licensed, dictate the size of the market, and in one way or another require a debt position to be held to hold a swap. CDSs are much more like insurance than options or short selling shares. Equity shares (long or short) and options are generally instruments with evenly dispersed payouts. CDSs are betting on a (usually) improbable event, and that low probability is matched with a massive payout.
When limited to covering a risky investment, a CDS switches from an aggressive bet to a conventional tool. This also limits the size of the market, eliminating situations where is far more profitable for investors to have a firm go under. Instead of attacking what is difficult to understand, spend some time looking at the incentives these instruments offer, and build their future in a way that limits morally hazardous opportunities.
