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(Niels Laan/iStockphoto)
(Niels Laan/iStockphoto)

ROB explainer

What are credit default swaps? Add to ...

The European Union executive is threatening to ban some credit default swaps in a swipe at speculators who officials say made huge bets against the euro and the chances of Greece not repaying its debt in recent weeks.

Germany is also asking for U.S. help to curb traders' bets on a possible default in the euro zone. The country is calling for the United States to help curb the use of credit default swaps on sovereign debt. Greek officials have blamed financial speculation for some of the market pressure on their bonds.

But what exactly are credit default swaps, and why are European officials so concerned about them right now?

Credit default swaps are simply a form of insurance. They allow someone who is nervous about a default on a bond, whether it's issued by Greece, another country, or a company, to buy insurance.

If you're nervous about a default on that bond, you can buy insurance, and if the bond does default, the insurance covers you. It's no different than if you're nervous about a car accident or a house fire, you buy insurance, and if you have a car accident or a house fire, the insurance covers the money you otherwise would have lost.

The one difference is that you can buy insurance against bonds that you don't own. If I call my insurance company and say I want to buy insurance on my neighbour's car or house, they're going to say no. But the credit default swap market is wide open to anyone, so you can buy insurance against bonds you don't own. These are called naked credit default swaps.

I think that's what regulators are really concerned about because you can have a lot more people buying insurance than there are actually bonds, which can magnify the effect of any speculation.

The concern of the politicians in the European union and Greece is that all of these bets against Greece make the country's situation appear worse than it really is, and that creates fear.

Everyone can see that the credit default swap market is nervous about Greece and that people are buying a lot of insurance against a Greek default. That makes more people concerned about a Greek default, because they wonder, 'What do they know that I don't know?' That makes it harder for Greece to raise money in the bond market because people think, 'If others are so concerned about default, why would I buy bonds?' and that increases the risk of default.

The flipside is that there's a belief among many that this is just scapegoating. They believe that credit default swaps aren't the problem, that the problem is Greece, and that the country's mismanaged and it has a huge deficit and the real risk of default comes from the poor fiscal situation in Greece. They believe the government is trying to shift the focus onto the speculators because after what's happened in financial markets in the past couple of years, the idea of speculation has become a very dirty word.

In fact, the German financial regulator, known as BaFin, recently came out with a report that suggests there's no evidence that speculation on Greek bonds has gotten out of hand or that it's doing anything to drive the bond market, and in fact it's many derivative experts who, granted, are a little biased, will tell you that the Greek bond market actually is more nervous about Greece than the credit default swap market. Their argument is hey, if you want to ban credit default swaps, maybe you should just ban selling Greek bonds entirely, but of course we know that won't happen.

They've been very popular in recent years, but they've been around for a long time. It's a bit hard to tell because it's not a transparent market. You and I could agree to a credit default swap right here and shake hands on it and no one would be the wiser.

They developed markedly in the last 10 to 15 years and the market has exploded, but they've been around a while. And that lack of transparency is something that almost everybody agrees needs to be addressed. People will want to know who is trading credit default swaps on Greece and for what purpose. If we knew that information more clearly, I think that a lot of the fears around CDS might be dispelled, so that's going to be the first step in smart regulation of CDS, to at least make it clear who's trading them, who's backing them, how much capital they have.

That should dispel a lot of fears, and if that isn't enough, the next stage is to start looking at curbing some of the use of credit default swaps. That said, regulation is all the rage right now and I suspect regulators, especially those who feel they are being targeted by speculators in the CDS market, will try to go even further than that right away.

Right now it's all speculation. The idea would be maybe to eliminate naked credit default swaps, in other words, saying that you can only buy insurance if you own the bond, like you can only buy house insurance on your own house. That would climate speculation and basically mean that anyone who was buying the insurance would be a natural hedger, meaning they have exposure. That's probably what people will aim for but it's not clear at the moment what they will try to do.

Why wouldn't we just call them bond insurance? Part of this goes back to the financial markets' love of anything that sounds complicated. Simply what it is though, is I swap the risk of default with you. If you're on the other side, I swap it with you for a stream of premium payments. It's a fancy name, but really what we're talking about is insurance.

Again, people blame credit default swaps, but really what happened was that AIG as an insurance comp may viewed CDS as a form of insurance. They said we're good at life insurance, and all sorts of insurance, we'll be good at this kind too. Turns out they weren't.

They wrote a lot of CDS and sold a lot of insurance on bonds and when it began to look like many of these bonds would default, AIG and regulators realized that the company wouldn't have the capital to pay all the claims that could come down the pipe.

So AIG was forced to take a huge bailout and likely would have gone under without it. A lot of people have said it's the fault of CDS. I would argue it was the fault of really, truly bad management at AIG and not understanding the risks they were taking and not setting aside the proper amount of capital. So that really put AIG in the news and really, really put credit default swaps in the news and gave them a bit of a bad name.

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