• 01 Jun 2012 at 4:03 PM

The CDS Market For Lemons

A stylized picture of a credit default swap is that it’s a way for a bank to offload to the market the credit risk of loans that it makes, while still funding those loans and making a profit on them. If you start from that stylized picture, you must at some point get comfortable with the stylized fact that this market is probably rife with insider trading. Turns out it is! Part of the reason for that is that it’s maybe legal,* part of it is just the general run of market-participant scumminess,** but there’s also the fact that the basic model sort of requires it. Here is the basic model:

  • private side bank employees evaluate a company for a loan, using lender materials that contain nonpublic information and banker relationships that are all about nonpublic information,***
  • private side bank employees negotiate and fund that loan with a company,
  • [magic happens], and
  • public side bank employees buy CDS on some but not all of the companies that the bank lends to in sizes that vary among companies.

So, I mean, I generally trust that most banks are over-compliant on this point and the magic happens behind a Chinese wall and so forth, but still, that sequence of events should make you a tiny bit suspicious if you’re anti insider trading in CDS.

Anyway, if you continue on with that stylized picture you’ll notice that, while the existence of traded CDS allows for a two-sided market of public-market speculators who buy CDS to bet against companies that they don’t lend to (or that they lend to only in public bond form), the origin of and net demand for single-name corporate credit protection comes largely from banks who do private-side lending and are probably hedging that lending. This is basically true.

That sucks for the CDS writer, doesn’t it? Read more »