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? Abstractly, the writer has no inside information on the reference credit, but is insuring a bank, who abstractly has inside information, against a default on an instrument that the CDS writer may not have even seen.**** And, in fact, it turns out that companies who have traded CDS do tend to default more frequently than similar companies that don't have traded CDS, which NY Fed researchers chalk up to the empty creditor hypothesis ("hedged creditors cheerfully plunge issuers into bankruptcy rather than working out a deal"), but which I think is richly suggestive of alternate mechanisms, of which "banks preferentially buy CDS on companies that they secretly know are dicey" is a fun one.*****
But this should in theory create a market for lemons: why would you sell CDS to a bank? They know more than you, they're making an informed decision, and the only possible reason for them to buy CDS is that they think it's a bargain relative to the risk they're offloading. Right?
Wrong! Here is this discussion paper just posted by the German central bank, about the interaction of banks, Basel II/III capital adequacy regulation, and CDS markets. From the nontechnical introduction:
Darüber hinaus verdeutlicht die Analyse eine Interaktion des zuvor genannten Effektes mit den Anreizen der Bank, Kreditrisikohandel mittels CDS zubetreiben. Wenn die Regulierung CDS-Kontrakte als Instrument zur Kreditrisikominderung anerkennt ...
Oh, wait, sorry, there's an English version too. Here:
We also find an interaction between the ... effect of regulation and the bank’s incentives to engage in credit risk transfer with CDS. When regulation accepts CDS as an instrument to mitigate credit risk, which is true for Basel II (and III), a risk neutral bank will engage in CDS trading even if the CDS price is unbiased, i.e. the CDS price equals the expected loss rate of loans. In particular, due to the substitution approach in Basel II (and III) the risk neutral bank finds it optimal to fully hedge its exposure to credit risk as long as the CDS price is unbiased. An upward or downward biased CDS price, however, implies an underhedge or an overhedge of the bank’s credit risk exposure.
There's more, particularly about how the "substitution approach" in the Basel regs (in which the CDS writer's credit is used in computing capital rather than the reference obligation's credit) dampens the tendency to over/underhedge in mispriced CDS markets, you should read it, if you like tons of math to prove things some of which are sort of intuitive. But let's focus on the basic intuitive thing which as I read it is:
(1) if you are a bank, and you have no capital regulation, you should lend as much as you want and buy CDS if and only if it's underpriced relative to the risk it's hedging, because you are risk-neutral and strong like bull; but
(2) if you are a bank and you have capital regulation, you should lend somewhat less because [math] and buy CDS if it's either underpriced or roughly fairly priced relative to the risk it's hedging, or even maybe if it's a bit overpriced, because you get a capital benefit from buying CDS, and this allows you to lend more and put your deposits to work and clip your NIM and so forth, and you are not such a risk-neutral cowboy any more now that the regulator has its eye on you.
Thing (2) is fairly straightforward in the abstract and infinitely and gloriously game-able in the real. But thing (1) is a thing that only an economics paper could love, because if the CDS market developed as "this is a thing that (well-informed lending) banks buy only when (they know that) it's underpriced" then who would sell it? No one that's who. And, of course, the CDS market in fact developed as "this is a thing that banks buy to improve their regulatory capital." And there were sellers, in part because let's be honest you only need X sellers and there are always some people who don't think things through, but also because the banks could credibly say "we love these credits, we really do, we'd never sell them, but you see, regulation ..."
Maybe all of that is kind of obvious? I don't know. Mostly I just like German central bankers pushing the benefits of the CDS market, which I feel like is ... less popular among European central bankers? And I particularly like that their math more or less proves that the CDS market couldn't exist in anything like its present form if Basel hadn't made it marketable.
Thilo Pausch & Peter Welzel: Regulation, credit risk transfer with CDS, and bank lending [Deutsche Bundesbank]
Stavros Peristiani: Are CDS Derivatives Associated With Higher Corporate Defaults? [FRBNY]
* Not legal advice, consult your doctor, etc.
** Really, I loved that story, it's like at Galleon it was a mark of shame not to be insider trading, everyone was all "oh yeah I totally gave insider information to George Soros man." How widely true do you think that attitude is? Was? Is recent meh hedge fund performance partly due to the effect of the Galleon wiretaps and prosecutions? Discuss amongst etc.
*** How many bank loans are about an M&A or capital markets banker saying "hey, these guys told me they are going to [do a merger | issue securities | whatever], we need to be in their line to get a shot at that business?" Many of them, that's how many. How many of those plans are material to the credit?
**** I'm calling this a story about underwriting because whatever but it could also be a story about contracts. A story I've heard involves banks lending to certain emerging market sovereigns with high rates and very forgiving terms, and then offloading the credit risk in CDS markets. If the sovereigns defaulted on the tighter terms in public bonds, the banks' privately negotiated and undisclosed loans were deliverable, meaning that the banks were arbitraging CDS markets by charging the sovereigns for the riskiness of their terms but not being charged by the CDS market for the same riskiness. There are limits to this form of arbitrage, but they are nonzero.
***** Here is Felix Salmon talking about something related, specifically that if you want your banks to be, like, conduits of credit in the economy or whatever, you want them to keep their credit risk rather than offloading it to greater fools. I have no problem with that; my point is that you especially want this if you're the fool!