Bankruptcy

De-Detour: CDS Nudity on the Exotic Fringe

By Anna Gelpern

A recent FT Editorial implicates a topic I -- basis risk in emerging markets (EM) credit derivatives.  The problem is this:  If you want to buy protection against default by a big U.S. firm--say, GM--you buy a CDS contract on a GM bond.  But even in the leading emerging markets, it is often difficult to buy protection on major corporate credits, especially if you want to hedge against default on local-currency or other non-dollar/euro/yen obligations.  This is because local financial markets are relatively thin.  Your choice then is to buy a liquid standardized instrument, such as a CDS on foreign-currency sovereign debt, or to negotiate an expensive bespoke contract with a party willing to take the precise local risk off your hands.  If you opt for the liquid standardized sovereign CDS, you get partial protection.  This means that if your borrower defaults but the government is still servicing its dollar-denominated foreign bond, you cannot collect.  Herein the basis risk.  Note that even if you were able to arrange bespoke protection, you could be taking on more counterparty risk, since the only people willing to insure illiquid local instruments might be local institutions more exposed to measures such as capital controls ... or risk-hungry fringe elements that might flake out on you.

How is any of this relevant to the current debate on regulating "naked" CDS, or credit protection not matched by exposure to the underlying credit (aka fire insurance on your neighbor's house)?  It goes to the difficulty of defining the subject.  A CDS that might appear naked at first blush could in fact be partially clothed; and instead of encouraging better hedging, we might end up eliminating what partial protection is available in less liquid markets (damage insurance on your block?).  Not to say that EM basis risk should even remotely drive the discussion, but the example does expose the challenge of figuring out not just the legal terms of the regulated instruments, but the often less-than-intuitive ways in which they are used.

Full post as published by Credit Slips on March 12, 2010 (boomark / email).