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January 2021 | Issue 230
Opinion Credit derivatives
Speculative protection buying censures managements that seek only to enhance their own wealth
Duncan Sankey
Portfolio director and head of credit research Cheyne Capital
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The Catholic church misses the mark when referring to CDS as ‘finance of chance’
A TV schedule that is even more repeat-laden than usual offers plenty of scope for catching up on reading. I would therefore like to recommend: the Oeconomicae et Pecuniariae Quaestiones from the Catholic church’s Congregation for the Doctrine of the Faith. This document sets forth across 34 points some ethical considerations regarding aspects of the current (capitalist) economic and financial systems in lucid, nuanced prose. Its recommendations are judicious and mostly actionable.
Written in 2018, Oeconomicae et Pecuniariae Quaestiones anticipated many of the ethical footings for the current efflorescence of ESG and development of regulation surrounding such issues as market manipulation and, at a much more specific level, Isda’s efforts to combat narrowly-tailored credit events and other abuses of CDS. That it is informed by Christian faith goes without saying. However, the ethical framework it advocates resonates more widely: most people would concur that financial markets cannot function without at least a nod to the golden rule, whether expressed through the categorical imperative or Luke 6:31. (“And as ye would that men should do to you, do ye also to them likewise.”)
Misunderstanding how CDS operate
However, in common with many critiques from outside the industry, the Catholic document’s composure slips somewhat when it comes to credit derivatives, which it caricatures rather than characterises as “a finance of chance, and of gambling on the failure of others… [which] creates a unique case in which persons start to nurture interests for the ruin of other economic entities”. And, in common with many critiques from outside the industry, this seems grounded in a misunderstanding of how CDS operate.
It is a truism to note that in a two-way market such as CDS, not everybody can be long. Some players sell CDS, in which case they cannot be gambling on anybody’s failure. Most CDS sellers are not gambling on anything. They are simply harvesting a premium for credit risk in the same way as would the purchaser of a corporate bond, the only difference being that CDS disaggregates the credit risk of the corporate entity from the rate risk associated with the underlying sovereign. This is no “speculative transaction of virtual wealth”.
Nor is there any nefarious intention behind most protection buying. The banks, pension funds and insurance companies that form the bulk of CDS buyers seek to hedge bond and loan positions not out of any predatory animus but rather out of a desire to protect the companies and investments over which they are stewards, by mitigating uncertainty or liberating capital. In doing so, they marry the profit that is “intrinsically necessary for every economic system” with social responsibility, which the authors champion.
Speculative shorts serve a purpose
And, while we have the toolbox out, speculative protection buying does not necessarily yield unethical outcomes. Once again, by buying protection an expert market participant is expressing a view on the directionality of a company’s credit quality. That is vital information for other market participants that is synthesised in the price of the CDS and which enhances market liquidity.
Moreover, speculative protection buying also censures those corporate managements that seek to enhance the wealth of shareholders (and usually management as well) merely by filching returns due to other stakeholders (in this case, creditors) rather than augmenting the value of the company through prudent investment and risk-taking. In this way, speculative CDS longs can draw attention to managements pursuing policies aimed at increasing “the mere profits of shareholders, damaging… the legitimate interests of those who are bearing all the work and service benefiting the same company…”
Like so many critiques of credit derivatives, those of this document (understandably) focus on their abuse and excesses. However, it would be wrong to focus exclusively on misuse and ignore the benefits that CDS bring to the efficient functioning of financial markets. Individuals may act unethically; market regulators and industry bodies will continue to reform regulations to stifle such behaviour. But to assume that CDS and the CDS market are unethical would be a cardinal sin.
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Global credit funds & CLO's
January 2021
| Issue 230
Published in London & New York.
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