Clothing the "Naked" Swap Market

The Wall Street Journal is reporting a bill circulating in Congress that seeks to ban "naked" credit-default swaps.

Credit-default swaps (CDSs) are, in the simplest of terms, insurance contracts that insure the purchaser against corporate debt default. CDSs are sold by hedge funds, investment banks, and some insurance companies (AIG, for example), and thanks to a lack of regulation, these CDS-selling entities are not required to maintain a minimum capital level to support large-scale corporate defaults.

The CDS purchaser may want a CDS because the purchaser owns bonds or other corporate debt insured by the CDS. However, a "naked" CDS is a CDS purchased by someone that does not own the debt insured by the CDS; such a purchaser wants the CDS for speculative purposes and stands to make a profit if the debt issuer defaults. Likening the purchase of naked CDSs to taking out a fire insurance policy on your neighbor's home, critics claim that naked CDSs create unnecessary systematic risk by inflating the damage caused by corporate debt default and want naked CDSs to be banned completely. Opponents of such a ban claim that removing speculators will dry up the CDS market's liquidity, effectively making non-naked CDSs too expensive to be used as default insurance. Other proposals for dealing with the CDS market include imposing minimum capital requirements on CDS dealers and creating a central CDS clearinghouse, both to limit the counterparty risk of the CDSs.