The massive struggle to bring the value of derivatives down to earth is underway. The latest move is by the state of New York, a leading center of regulation of the insurance industry. The yelps heard from derivatives industry representatives is a sign of the emerging political fault lines.
They are, finally, re-classifying credit default swaps where the protected bond is actually held by the buyer of protection as “insurance” (duh) and thus subject to the requirements that the seller hold sufficient regulatory capital to back up the insurance protection offered.
A brief summary of how CDS’s work:
- An investor like a pension fund may buy a bond (C: “Credit” – the reference ) issued by GM that is worth $10 million.
- If the pension fund is worried (about GM, no, come on, really?) that the issuer of the bond will default (D: “Default”), they can sell (S: “Swap”) the risk to a counter-party, a seller of a CDS, for a fee (typically, 2% of the value of the bond, so, in this case, $200,000) payable each year during the life of the bond.
- If the issuer, GM, defaults, the seller of the CDS will have to pay the pension fund the outstanding value of the bond. AIG is a giant issuer of CDS’s like this.
This may strike most followers of this issue as a bit like closing the barn door after the horse has fled the barn. There is something like 60 trillion dollars of notional value of CDS’s out there and only a fraction are written to protect someone who actually holds the underlying.
A much larger market is made by selling CDS’s that reference a bond issued by a third party like GM but where the purchaser of the protection has not actually bought the bond. They simply want to bet on the possibility of a default – in this case they would get up to $10 million without ever having actually had to purchase the bond.
Nonetheless, this is the kind of move that is likely to change the dynamics of this asset class in important ways – namely, to slow it down and possibly alter its shape and impact for many years to come.