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Wary of CDS: Warren Buffett

A few years ago, credit-default swaps (CDS) were obscure financial instruments designed to protect creditors from the risk of borrower defaults. Nowadays, they are prime contenders for any discussion on how to reform the financial system. Supporters will tell you that CDS contracts are an essential hedging tool. The critics are more likely to cast them as the stormtroopers behind the 2008 financial crisis. Famously, Warren Buffett termed them “financial weapons of mass destruction”. And the label has stuck.

Love them or loathe them, it looks as if the CDS is coming to China. Shi Wenchao, secretary general of the National Association of Financial Market Institutional Investors, last week told reporters in New York that CDS will be introduced by the end of the year.

Shi emphasised their role as a hedging instrument: “We believe CDS is a neutral risk-management tool,” Shi said. “It is neither evil nor good,” he told Bloomberg.

But China isn’t planning to import the idea wholesale. These will be CDS with Chinese characteristics. In fact, their name looks likely to be changed to ‘credit risk mitigation contracts’ – as if to distance their holders from the default situations that the contracts are supposed to guard against.

The Chinese also plan to limit the amount of leverage that can be used to set up credit swaps. Nor will they permit contracts to be written on higher-risk assets such as subprime mortgages, said Shi. Investors in the derivatives will also be required to own the underlying security, he added, so as to counter speculation around so called ‘naked’ positions.

Will the proposals mean that the toxic reputation of CDS is tamed before they cross the Great Wall?

Perhaps, muses Donald Straszheim. The head of China research at International Strategy and Investment Group told Bloomberg: “It’s too bad that we in America and in Europe did not have those kinds of limitations two or three years ago.”

And market participants seem to believe that China’s CDS move is a welcome one. Certainly, it could alleviate some of the pressure on the banks. “One of the major problems China faces is that the commercial banks do not have the necessary instruments or mechanisms to transfer credit risk, yet as holders of huge amounts of credit assets, they bear most of the risk for the financial system,” Zhao Chuanxin, manager of ICBC’s financial markets division, told China Securities Journal. “We really hope that CDS can be introduced to China.”

Credit-default swaps may also help in the ongoing development of the local bond market (see WiC75). In particular, China Securities Journal thinks it could make it easier for small-and medium-sized firms to sell bonds, with CDS ‘insurance’ on offer for riskier investments.

Others doubt that the new swaps will have much of an effect. “A precondition of the introduction of CDS is that credit market liquidity is sufficiently high. But the water is stagnant now,” a state-owned bank official told 21CN Business Herald. He said that the secondary market for debt products is particularly slow.

The quandary for regulators is that the swaps may be little used if too many restrictions are imposed. On the other hand, nobody wants to see the speculative free-for-all that led to market meltdown in the US. A popular tactic was to short a company’s stock, forcing the price down, and then go long on default swaps on that company’s debt. This offered two potential avenues to profit, and some investors made out handsomely.

Most didn’t, of course, including the investment banks that facilitated many of the riskiest contracts – and thanks to shorting of their own CDS, stared into the abyss in October 2008.

China will be hoping its modified CDS scheme avoids similar consequences. Previously, bureaucrats have been cautious with financial innovation, launching on a step-by-step basis. Margin trading and short selling arrived on a trial basis earlier this year and CDS will be introduced in a similar fashion. That probably means the regulators will put on the brakes on signs of abuse of the new instruments.

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