Should We Ban Naked CDS?

Brad DeLong submits:

Should we ban naked CDS?

I say, narrowly, no -- that if we can get proper clearing, transparency, and capital adequacy requirements in place, banning naked CDOs would not do any good and would, in fact, do a little bit of harm. However, it is a close call, and if we can't get proper clearing, transparency, and capital adequacy requirements in place, then we should absolutely ban them.

Let's go back to first principles. The direct benefits of having more developed, liquid, and sophisticated financial markets are threefold:

1. They allow people to buy insurance: People facing or holding too much of one particular risk, can trade a piece of it away to others. The insurance buyer makes a negative expected value bet, but one that, given the magnitude of the distress that would be caused if the risk became a reality, they are happy to make. The insurance sellers make a positive expected value bet.

2. They facilitate saving and investment: People with wealth who want to spend later can make win-win deals with people with ideas who need financing to turn those ideas into productive and profitable enterprises.

3. People who have done research and learned information about the structure and likely evolution of the market can bet on their knowledge: They win because they make their positive expected-value bets, and everyone else wins because after they have bet, financial market asset prices better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.

The disadvantages of having more developed, liquid, and sophisticated financial markets are fourfold:

1. People who are excessively and irrationally averse to risks can trade those risks away at a price, and so lose wealth because they are shrinking at shadows.

2. People who are excessively and irrationally unconcerned about risks can trade to accept those risks, and so lose wealth because they are excited by the thrill of tossing the dice.

3. A more developed financial market is one in which it is easier to make money by unfairly appropriating somebody else's information through insider trading.

4. A more developed financial market is a more fragile market: When prices move suddenly and bankruptcies and failures to deliver emerge, it destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression.

In general, you want to set up your financial markets so that they do as good a job as possible at (i) rewarding those who work hard doing research into fundamental values, (ii) matching individuals with wealth to save with entrepreneurs who have ideas to try out, and (iii) enabling those who want to shed diversifiable risk to do so.

Further, you also want to set up your financial markets to minimize (i) the irrationally risk-averse's ability to throw away their money, (ii) the irrationally risk-loving's ability to throw away their money, (iii) the unfair appropriation of other people's information through insider trading, and (iv) the chance that a chain of bankruptcies and failures-to-deliver will disrupt the web of trust, cause a flight to liquidity and quality, and create a depression in the real economy.

There is an eighth consideration, however, and which way it cuts -- whether it is a benefit or a disadvantage -- is unclear:

• A more developed financial market increases the chance that somebody who thinks market prices are too low and wants to buy will find a counterparty who thinks that market prices are too high and wants to sell.

This eighth consideration is definitely not win-win. One of the two parties is definitely wrong -- prices right now are, if they are not exactly right, either too high or too low. Both think that they are getting a good deal, but both cannot be correct. As far as the two parties are concerned, these trades are at best zero-sum and probably less than zero sum: risk is, after all, increased.

However, when all the people making too-high and too-low bets meet in the marketplace, prices move until the number who think prices are too high (and are willing to put their money behind that belief) equals the number who think prices are too low (and are willing to put their money behind that belief).

This reveals the balance of opinion, and so moves financial market asset prices to a place where they better reflect fundamental social values and scarcities, and so are better guides to private and public economic planning.

On the other side of the argument, somebody is holding a portfolio that is based on false beliefs about the way the world works. Such people are especially likely to fail when reality comes calling -- and so encouraging these directional-bet transactions increases the chance that, when reality comes calling and when prices move suddenly, they go bankrupt or fail to deliver--and that destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires, and the result is depression.

George Soros believes that this last consideration should lead us to limit the extent to which our financial markets are friendly to directional bets. Thus he calls for the banning of "naked" credit default swaps, as quoted in his WSJ editorial on March 4, 2009, "One Way to Stop Bear Raids: Credit default swaps need much stricter regulation :"

Tim Geithner disagrees, as quoted from Seeking Alpha :

I call this one, narrowly, for Geithner: The key elements are clearing, transparency, and capital adequacy requirements that maximize the flow of information into market prices from the fact that people with money are willing to put it on the line to back their predictions. And, that, minimizes the chances of disruption in the web of trust.

Disclosure: No positions

See also Stocks vs. Bonds on Steroids on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.