Why banks shy away from credit default swaps

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Why banks shy away from credit default swaps

The turmoil in the financial sector is far from over. The eyes of bankers and investors are mainly focused on Deutsche Bank, which suddenly lost confidence in the stock market on Friday. Reason enough for Andrea Enria, Chairman of the Supervisory Board of the European Central Bank (ECB), to demand changes.

Enria sees a great danger in the so-called credit default swaps (cds), with which investors can buy off their risk in the event of a bank bankruptcy. The value of Deutsche Bank CDs rose enormously last Friday, after which the value of the bank itself collapsed.

‘A CDS is not a product that you and I trade in,’ explains BNR’s house economist Han de Jong. ‘It is reserved for professional market parties.’ With a CDS, a party can insure itself ‘in the event of a debtor’s default’. ‘If you are a large party and you have an interest in Deutsche Bank, for example, and you are afraid that it will collapse, you can buy a CDS. If the bank really defaults, then the CDs pay out and you get a lot of money.’

Deutsche Bank is the latest victim of speculators who ‘gamble’ on the collapse of the bank by trading Deutsche Bank credit default swaps. (ANP / Associated Press)

During the financial crisis in 2008, the CDs were traded extensively, but also in edited versions of the CDs, which made the initial value unclear. Such CDs were then packaged in a package with other insurance papers. That hasn’t really changed since then. It remains a fairly obscure part of the market,’ says the house economist.

Nevertheless, insurance papers are important for the financial sector, says De Jong. “It’s an easy benchmark to look at if you want to assess how the market feels about a possible bank collapse.”

Shareholders are also watching closely. If you see that a CDS is becoming much more expensive, then that is an expression of the market that sees the risk of a bank going bankrupt increasing.’ This can then mean a fall in the share price of the bank. ‘This is also noticed by savers,’ explains De Jong. “They might collect their deposits then. (…). It therefore influences the entire atmosphere around an institution.’

Big consequences of speculating

However, trading in a CDS has also become a way of speculating in a bank failure. ‘These are fairly non-transparent products, because you don’t know who trades them. They are also very liquid, so you can easily influence the price of a CDS. If you’re up to no good and you want to topple an institution, you buy up a lot of credit default swaps. Then the price goes up and other shareholders get nervous.’

‘It starts relatively small, but it is certainly not impossible that you can undermine an institution as a result’

Han de Jong, BNR’s house economist

What happens next is a self-fulfilling prophecy, says De Jong. ‘It starts off relatively small, but it is certainly not impossible that you can undermine an institution as a result.’ That is why the ECB wants adjustments to the system. ‘You can change the rules, but the fact that there is little liquidity in a CDS means there’s not much you can do about that. Because there are relatively few parties active in that market.’

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There are other options for making adjustments, thinks De Jong. ‘By centralizing trade you can make it much more transparent, which seems sensible to me. This deprives opportunistic speculators of their room for manoeuvre.’

But despite the ECB’s intention, banks should not expect to get rid of speculators quickly. ‘These kinds of processes are quite long. In the case of Deutsche Bank it will not have a major impact’, De Jong expects.

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