There are not many bets that a bookmaker will refuse to take but there are some. For example, it is not possible to get odds on when the queen will die. Similarly there are few economic outcomes that cannot be traded, hedged or arbitraged in today’s market, thanks to the development of structured products such as credit default swaps (CDS).
However, perhaps the issue of sovereign debt should be off-limits to large parts of the derivatives market. This is what was suggested by James Rickards in the Financial Times this week. Rickards, currently a senior managing director at US-based market intelligence firm Omnis and previously general counsel at Long Term Capital Management, believes that the recent economic woes in Greece have highlighted the shortcomings of the CDS concept.
This concept relates to the use of CDS as an insurance against debt which is simple enough. However, when the insurance is against sovereign debt and the policy holders have no insurable interest in the underlying asset, then the concept runs into questionable ethical territory.
As Rickards says: “When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.”
Burning down a house is one thing but burning down a whole country is a quite another. As Greece’s public finances have unwound, Greek government bonds and CDS’s have experienced huge fluctuations. The price of CDS have soared and the value of government bonds have plummeted.
And it’s not just Greece that has its public finances in a mess. Ireland, it is feared, could default on its soaring national debt, evidenced by the fact that the cost of buying insurance against Irish government bonds trebled in a week. Meanwhile the Spanish government recently had to increase the interest if pays on its bonds, which cost the country €12 million.
Rickards feels that the CDS market should be confined to “buyers who an underlying interest in the risk being covered and sellers who are regulated as insurance companies with adequate reserves. Otherwise, “the market will remain a reckless enterprise bent on arson”.
It is a similar argument to those that were voiced during the concern over short-selling and there will be similar rebuffs, stating that a CDS is a valuable tool for investors to hedge their liabilities and a legitimate trading vehicle. But to have a situation where speculators can profit from a country defaulting on its debt does seem wrong and the kind of thing that would no be allowed in a betting shop. Perhaps this will become the new yardstick for regulators charged with reforming the capital markets – what would the bookies do?