the economics of cds

8/3/2019 The Economics of CDS

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The Economics of Credit Default Swaps (CDS)Robert A. Jarrow*

July 10, 2010

AbstractCredit default swaps (CDS) are term insurance contracts written on tradedbonds. This paper studies the economics of CDS using the economics ofinsurance literature as a basis for analysis. It is alleged that trading inCDS caused the 2007 credit crisis, and therefore trading CDS is an "evil"which needs to be eliminated or controlled. In contrast, we argue that thetrading of CDS is welfare increasing because it facilitates a more optimalallocation of risks in the economy. To perform this function, however,the risk of CDS seller failure needs to be minimized. In this regard, gov-ernment regulation imposing stricter collateral requirements and higherequity capital for CDS traders need to be imposed.

Key words: CDS, collateral, defaults, bonds, insurance.

1 IntroductionCredit default swaps (CDS) are term insurance contracts written on the no-tional value of an outstanding bond. The first CDS were traded by JPMorganin 1995.1 Since that time, CDS trading has grown dramatically as recorded inTable 1. These figures are from the 2010 International Securities Dealer Associ-ation (ISDA) market survey. As noted, ISDA started collecting data on CDS in2001. For comparison, the total outstanding interest rate & currency derivativesand equity derivatives are also included in this table. As evidenced, the CDSmarket exhibited exponential growth between 2001 - 2007. At its 2007 peak,total outstanding notional for CDS was over 62 trillion dollars. After the cri-sis, however, these numbers have halved to just over 30 trillion dollars in 2009.Most of this change in outstanding notional has occurred through "portfoliocompression" as demanded by the regulators where long and short credit deriv-ative positions on the same underlying credit entity held by the same institution

* Johnson Graduate School of Management, Cornell University, Ithaca, New York 14853and Kamakura Corporation. email: [email protected].

1See Newsweek, October 6, 2008, "The monster that ate Wall Street," M. Philips or Fi-nancial Times, March 24,2006, "The dream machine," G. Tett.

1
mailto:[email protected]:[email protected].


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are netted (see Duffie, Li and Lubke [16], p. 4). The reduction is not due todecreased trading activity in CDS. This assertion is supported by the relativelystable outstanding notional of equity and interest rate & currency derivativesover this same time span.

Insurance contracts on debt existed long before the start of trading in CDS.Municipal bonds are commonly insured by private insurance companies (seeFabozzi [18], p. 182) and individual mortgage loans often have mortgage insur-ance initiated by the lenders, especially those mortgages that are issued withhigh loan to value ratios (see Fabozzi [18], p. 220). And of course, for decadesGinnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac have all providedinsurance for residential mortgage loans (see Sundaresan [50], p. 319).

Ithas been argued in the financial press that the unrestricted trading in CDSwas a key contributor to the severity of the credit crisis.f For these reasons,recent financial regulation reform aims to control and/or to limit the use of thesederivatives (see Litan [35], Duffie, Li and Lubke [16]). To understand the truthor falsity of these allegations and the effectiveness of the proposed regulations,one must first understand the economics of CDS. This is the purpose of thispaper.

In fact, to understand the economics of CDS, one must first understand theeconomics of insurance, more generally. Then, one can apply these insights tothe specifics of CDS. This is the approach followed herein.

Our key conclusions are the following.1. The trading of CDS increases the welfare of the traders in financial

markets via the optimal allocation of risks, thereby lowering debt costs.2. The trading of CDS reduces market imperfections in the trading of debt,

especially enabling the taking of short positions. This reduction in marketimperfections facilitates the access to more debt capital, thereby lowering debtcosts.3. The possibility of CDS seller default, analogous to insurance companyfailure, reduces the welfare increasing role of trading CDS. Government regula-tion of the CDS collateral requirements and CDS seller equity capital is neededto maintain the benefits of trading CDS.

4. CDS defaults have a systemic risk component, which in the aggregate,might lead to the failure of financial markets. This negative externality is notcurrently priced into the contracts. If it exists, regulation in needed to correctfor this negative externality in the trading of CDS.

5. CDS spreads can be decomposed into (i) the expected loss, plus (ii) adefault risk premium, plus (iii) asymmetric information monitoring costs, plus(iv) a liquidity risk premium due to a quantity impact of trades on the price.Of course, these components are interrelated.

6. The valuation of CDS must take into account counterparty risk in theexecution of the contracts. This depends on the collateral requirements and2See CNNMoney.com, Sept. 30, 2008, "The $55 trillion question," N. Varchaver and K.

Benner, New York Times, Feb. 28, 2010, "It's time for swaps to lose their swagger," G.Morgenson, Bloomberg Businessweek, July 1 2010, "The financial reform law: a fig leaf," C.Harper and B. Keoun.

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credit worthiness of the CDS seller.7. For over-the-counter CDS, posting 100 percent of the notional in collat-

eral using riskless securities will completely remove counterparty risk and thenegative externality due to systemic risk and the failure of financial markets.It is surprising that this suggestion has not been made in either the financialpress or in the regulatory arena. An alternative clearing mechanism is a centralclearing counterparty (CCP). A CCP will reduce, but not eliminate the risk offinancial market failure.

8. Exchange traded CDS will also reduce, but not eliminate the risk offinancial market failure. This is true unless the exchange traded CDS becomefutures contracts, with daily settlement of gains and losses. Exchange tradinghas the additional benefits that it should reduce trading/liquidity costs andincrease transparency in both pricing and trading activity.

9. Rating agency error in evaluating correlated default risk generated twodistortions in the computation of equity capital, which was a key factor increating the financial crisis. One, it generated the perception of nearly risklesssecurities (AAA rated) with high yields, against which little equity capital wasrequired (e.g. Bear Stearns subprime hedge funds"). Two, it enabled highlyrated firms to sell CDS with little or no collateral and insufficient equity capital(e.g. AIC, see Congressional Oversight June Report [12]).

We note that conclusions (1) and (2) reduce a firm's cost of capital, whichin turn increases aggregate investment. This is a positive real effect on theeconomy from the trading of CDS. To maintain this positive real effect, however,government regulation is needed to control the failure of the sellers of CDScontracts (analogous to the failure of insurance companies). And, of course, if itexists, governmental regulation is needed to minimize the negative externalityin (4).

An outline of this paper is as follows. Section 2 reviews the literature on theeconomics of insurance. Section 3 then applies these insights to CDS. Section 4discusses the 2007 credit crisis, and section 5 concludes.

2 Economics of InsuranceCDS are an example of an insurance contract. As such, we can use the standardeconomics of insurance to understand the issues involved with the issuance ofCDS. An excellent survey text is Borch [8]. This section reviews the basics ofthis literature.

2.1 Pareto OptimalityInsurance enables the insured to hedge a risk and reach a higher level of utility.(see Borch [8], chapter 2; Varian [52],p.ll1).

For a competitive insurance market as a whole, given symmetric informationabout the risks (e.g. might be in reinsurance markets for risks like a hurricane),

3Businessweek, June 12, 2007, "Bear Stearns' Subprime Bath," Matthew Goldstein.

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trading in insurance contracts enables the market to reach a Pareto outcome (seeBorch [8], chapter 3). In a Pareto optimum no trader can change his portfoliowithout decreasing the utility of someone else. This is just the first theoremof welfare economics (see Kreps [33], p.199). Insurance contracts effectivelycomplete the market. Hedgers (the insured) avoid risks and speculators (theinsurers) accept the risk.

This literature assumes no default on the part of the speculators, i.e. insur-ance providers. It also assumes that there are no externalities in the insurancemarkets, which would result in a loss of the Pareto optimality (see Kreps [33],p.203 for the standard discussion). These are both related and important ob-servations which will be returned to below.

Information is often not symmetric for certain insurable risks (e.g. life in-surance, car insurance). If the insured have private information about the in-sured risks, then rational insurers price based on average risks. Due to adverseselection in the market, an equilibrium mayor may not exist. A signallingequilibrium can result, if there is a costly signal that can be used by the insuredto signal their private information. If a market equilibrium exists, however,it will no longer be a Pareto optimum. Nonetheless, insurance contracts willstill be welfare improving. This is the standard market for lemons problem andthe notion of a signalling equilibrium (see Akerloff [3],Spence [46],Varian [52],chapter 8).

A second problem can occur with asymmetric information as well. This isthe problem of moral hazard. Once insured, the insured may no longer takeprecautions about preventing the risk from occurring, generating an increasedlikelihood of the event. Anticipating this action, insurers may charge a higherpremium or modify the insurance contract to be incentive compatible (see Borch[8], chapter 6; Rothschild and Stiglitz [44]; Kreps [33], chapter 16). As withadverse selection, a market equilibrium will no longer be Pareto optimal, butinsurance contracts will still be welfare improving.

Similar to the symmetric information competitive equilibrium models, theasymmetric equilibrium models under adverse selection and moral hazard do notexplicitly consider default of the insurance providers. This issue is discussed inthe next section. In either competitive market structure, symmetric or asym-metric information, the existence of insurance contracts is welfare improvingand, consequently, the issuance of insurance contracts have a positive effect onthe real economy via the optimal allocation of risks.

2.2 Capital DeterminationThe insurance literature dealing with capital determination (capital reserves)was historically called collective risk theory.The standard problem is the following (see Borch [8], p. 150). Given is aninsurance company with a multiperiod horizon. Each period the company issuesinsurance policies, receives premiums, and pays any losses realized. Losses areindependent and identically distributed across time. When incurred, losses arepaid from the current premiums received plus equity capital. If losses exceed

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premiums and equity capital, then the firm becomes insolvent and ceases toexist. Any premiums remaining after losses can be paid out as dividends oradded to equity capital. Finally, government regulation imposes an insolvencyconstraint on the insurance company.

The objective of the insurance company is to maximize the present valueof dividends paid over the company's life. The decision variable is the level ofequity capital per period. The solution to this optimization problem is quitecomplex and dependent on the specifications of the loss distribution and insol-vency constraint.

In this optimization problem, the aggregate losses per period for the in-surance company are themselves the sum of losses realized on a collection ofindividual insurance policies (e.g. life insurance policies). If these individualinsurance policy losses are themselves independent and identically distributed,the law of large numbers holds per period. As the number of policies increase,the average of the losses realized approach the expected losses with probabilityone. Hence, for large insurance pools, the realized losses will be quite close tothe expected losses, and the equity capital reserves can be quite small. In fact,if the losses have finite variances, then the central limit theorem applies as well,and the average losses are approximately normally distributed. This aids in thecomputation of the insolvency constraint.

For many standard insurance products (car, life, home owners), the i.i.d.assumption is a reasonable approximation, and long histories of losses have beenaccumulated, making the determination of the loss distribution a well studiedstatistics problem (see Boland [6]).

Not surprising, this problem is analogous to that faced by financial institu-tions under Basel II,where the insolvency constraint is a value-at-risk constraint(VAR), see Jarrow and Purnanandam [29], Basak and Shapiro [4].

2.3 Premium DeterminationTraditional actuarial science determines an insurance premium as the expectedloss, plus administrative expenses, plus a risk loading. The risk loading is anexogenously specified compensation for insurance companies bearing the risk ofinsolvency (see Borch [8],p.163).

In economics, the insurance premium is determined by equilibrium consider-ations as discussed in the previous section on Pareto optimality (see Borch [8],chapter 3). These insurance premiums depend on the parameters and structureof the economy (endowments, risk aversion, information, equilibrium mecha-nism). Similar to the actuarial science literature, insurance premiums can bedecomposed into: (i) the expected loss, plus (ii) a default risk premium (as-suming perfect competition and symmetric information), plus (iii) asymmetricinformation monitoring costs (in a competitive market), plus (iv) a liquiditypremium for a quantity impact of trades on the price (due to imperfect compe-tition - an N person game). Of course, for any setting, these components areinterrelated.

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Most recently, insurance premiums have been determined using the meth-ods of arbitrage-free pricing (see Melnikov [37], Jarrow [26]). The arbitragefree pricing methodology applies to a competitive market with no market fric-tions. It takes as given the equilibrium insurance premiums as reflected in arisk neutral present value operator. The advantage of this approach is that onecan price insurance contracts, consistent with the insurance premiums complexdecomposition as given in the equilibrium literature, without explicitly char-acterizing the economy. This includes the asymmetric information competitiveequilibrium formulation and a liquidity risk premium as previously discussed.The liquidity risk premium inclusion is based on the extension of the arbitragepricing methodology as presented in Cetin, Jarrow and Protter [10].For imple-mentation, the risk neutral present value operator's parameters can be estimatedusing only market prices. This arbitrage free pricing methodology is the one wewill utilize below to value CDS.

2.4 RegulationRecall that the equilibrium models discussed above assume no default risk forthe insurance providers, i.e. all insurance contracts are executed as constructed.Of course, this simplification is violated in practice. Insolvency of insurancecompanies create welfare losses because risks which were thought to be hedged,were not. Furthermore, premiums which could have been used to provide asmall cushion for losses realized, were erroneously paid for insurance coveragenot provided. Such failure can occur purposefully (fraud) or by random mis-fortune. Given that insurance companies have limited liability and there arelarge monitoring costs for (small) investors to oversee the insurance companiesfinancial health, government regulation of the insurance industry is prudent. Inthe United States insurance companies are regulated by the separate States.Although each State's regulations differ, they all have various equity capitalrequirements designed to minimize the probability of insolvency (see Grossi andKunreuther [19]).

It is also interesting to comment on the capital requirements for reinsur-ance markets. Reinsurance is the insuring of an insurance companies's tail risks(hence, re-insuring) by third parties. These third parties are reinsurance com-panies (which themselves could be separate units of insurance companies, hedgefunds, or investment banks). Reinsurance is a negotiated bilateral contract be-tween an insurance company and the reinsurance provider. There is almost nosecondary market trading of reinsurance contracts+ (see Reinsurance Associa-tion of America [41] and Booth, et.al. [7]for more information of reinsurancemarkets).

The reinsurance market has a collateral requirement in addition to capi-tal restrictions (see NY State [39], Spiller [43]). To guarantee performance ofthese reinsurance contracts, certain sellers of the contract must post 100 per-cent collateral for the notional value, held in trust by a fiduciary. As long as the

4A traded form of reinsurance contracts are Cat bonds, see Jarrow [261.

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collateral is posted in riskless securities that are marked-to-market, the postingof 100 percent collateral completely removes the risk of contract failure. Thismechanism for removing counterparty risk can be used with over-the-countertraded CDS. We will return to this issue in a subsequent section.

3 Credit Default SwapsSimply stated, a credit default swap (CDS) is an insurance contract written onthe principal (notional value) of a bond for a fixed period of time. If the bonddefaults, then the insured delivers the bond and receives the face value from theinsurer. If the bond doesn't default, then the insurance lapses after the contractexpires. For the insurance protection, the insured pays regular premiums to theinsurer over the life of the contract. For a readable introduction to CDS seeAnson, Fabozzi, Choudhry and Chen [2].

More precisely, a CDS is a negotiated financial contract (a bilateral agree-ment) between a buyer and a seller of protection against losses (receiving lessthan the notional or face value) on a reference entity's bond over a fixed periodof time. The fixed period of time is usually measured in years, a typical CDSbeing 5 years. The reference entity can be a corporation or government, butit could also be a collateralized debt obligation's (CDO) bond, called an assetbacked security (ABS).

To obtain the protection against losses, the protection buyer pays regularpremiums, usually quarterly, to the protection seller. The premiums are propor-tional to the notional value of the contract. When a "default" or "credit event"occurs, the protection seller must settle the CDS claim and pay the losses dueto the buyer. A "credit event" includes a failure to payor a change in the inter-est or principal, bankruptcy, and types of financial restructurings (see Berndt,Jarrow, Kang [5]).

There are two types of settlements for CDS: physical or cash. If physicalsettlement, the CDS buyer delivers the reference entity's bond'' to the sellerand receives a cash payment equal to the notional value. If cash settlement,the buyer receives a cash payment equal to the difference between the "market"price of the debt and the notional value. The "market" price is determined viaan auctioning of the bonds in a predetermined procedure the details of whichare specified in the CDS contract.

Most CDS trade in an over-the-counter market between financial institu-tions, e.g. commercial and investment banks, hedge funds. The standard CDScontract form is generated by the International Swaps and Derivatives Associa-tion (ISDA). To trade CDS, the financial institution first needs a line of creditwith the counterparty. The magnitude of the line of credit depends on thehealth of the financial institution's balance sheet including the available equitycapital.

5In fact, anyone of a collection of similar bonds could be delivered, see Berndt, Jarrow,Kang [ 5 1 .

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When entering a CDS, the protection seller also needs to post collateral.The details or which are in the ISDA Master agreement. The exception beingthe situation where the protection seller is highly rated by a registered creditrating agency (e.g. Moodys, S&P, Fitch). For highly rated financial institutions,little or no collateral is necessary. The magnitude of the collateral posted variesdepending upon the credit risk of the counterparty and the specifics ofthe CDS.

According to an Office of the Currency report [40], the average collateralposted for a bank's net current credit exposure was 67% in the fourth quar-ter of 2009. The ISDA 2010 Margin Survey [23], Table 3.2 shows that 93% ofcredit derivative trades are subject to collateral agreements. The ISDA 2007counterparty credit exposure survey [22], Table 2a documents that the meanand median collateral percent posted in 2006 for credit derivatives is 23% and15%, respectively. Collateral is usually marked-to-market. If the rating of theprotection seller changes negatively over the life of the CDS, then more col-lateral needs to be posted. For CDS, collateral partially assumes the role ofan insurance company's equity capital to guarantee the contract's performance.We will return to this issue later in the paper.

Excluding the consideration of collateral, selling a CDS contract is equivalentto buying the underlying reference bond and shorting Treasuries" with identicalcoupons, maturity, and notional value to that of the reference bond. Indeed, aCDS receives premiums and incurs a loss if the debt defaults. Similarly, buyingthe reference bond and shorting the Treasury receives a spread to Treasury(premiums) and incurs a loss if the debt defaults. This equivalence can be easilyseen using the contingent claims approach to studying corporate liabilities (seeMerton [38]). This approach is also called the structural approach in the creditrisk literature (see Jarrow [25]).

To understand this equivalence, consider a zero coupon risky bond of matu-rity T and notional value K dollars issued by a firm. Merton [38]showed thatthis risky bond is equivalent to an otherwise equivalent riskless discount bondplus selling a European type put option written on the value of the assets of thefirm, where the put option has a strike price equal to K dollars and a maturitydate T equal to that of the risky bond. Furthermore, it is well known thatselling such a put option is equivalent to selling a T-year term insurance policyon the firm's assets with a notional value equal to K dollars. Hence, for thissimple example, the European put option is a CDS. Fortunately, this simpleexample generalizes to more complex coupon bonds including any embeddedoptions. This alternative economic characterization of CDS will be used in thenext section.

Lastly, with respect to CDS, we need to understand the term "counterpartyrisk." Counterparty risk corresponds to the risk that either side of the CDScontract will default and not honor the contract. Failure of the buyer occurswith a missed premium payment. In this case the contract is automaticallyterminated. The loss to the counterparty is the present value of the remaining

6 If such Treasuries do not trade directly, they can be constructed synthetically using Trea-sury STRIPs or other Treasury securities. This synthetic construction is now part of standardinterest rate risk management practice (see Jarrow [24]).

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payments. Failure of the seller occurs, if at all, on the date of a credit event whenthe claim is payable." These losses represent the realized difference between themarket value of the debt at default and its notional value.

The losses due to failure of the CDS buyer will be much smaller than thelosses due to failure of the CDS seller. This is because the present value of theremaining payments at failure of the CDS buyer is a discounted risk adjustedexpectation of the remaining premium payments where the premium paymentsoccur with a probability close to one. This is equal to the discounted riskadjusted expectation of the loss incurred at a credit event where the probabilityof the event is close to zero.f In contrast, failure of the CDS seller results inthe realized losses from the event (they occur with probability one). Althoughin both cases losses are incurred, it is the failure of the seller of the CDS that isof most concern. This can also be understood by using the insurance analogy:the CDS seller corresponds to the insurer, while the CDS buyer corresponds tothe insured.

3.1 Pareto OptimalityWhen considering CDS, there are two markets to consider. The first is theprimary market for the trading of the debt contracts themselves. The secondmarket is that for the CDS.

3.1.1 Primary Debt MarketsFor the purposes of this paper, we will take as given an equilibrium in theprimary market for debt contracts. Due to the asymmetry of information be-tween the borrowers and lenders, these markets involve both adverse selectionand moral hazard. Consequently, the resulting equilibrium will not (in gen-eral) be Pareto optimal, but it will still be welfare increasing. The reason theseasymmetric equilibrium are welfare increasing is that the owners of productionor technology often don't have the capital necessary for the investment. Debtmarkets bring together these participants. Credit markets are critical to thefunctioning of both the financial and productive sectors of our economy.

Much has been written on these primary markets, for example see Jensenand Meckling [32], Leland and Pyle [34], Stiglitz and Weiss [48], Aghion andBolton [1],and Holmstrom and Tirole [20]. This is a standard topic in the studyof corporate finance (see Ross, Westefield and Jaffe [45], Tirole [51]). Similarto the insurance premium, the yield spread to Treasury rates on a risky bondcan be decomposed into: (i) the expected loss, plus (ii) a default risk premium(assuming perfect competition and symmetric information), plus (iii) asymmet-ric information monitoring costs due to moral hazard and adverse selection (ina competitive market), plus (iv) a liquidity risk premium due to a quantity

7The CDS contract could also be terminated if the collateral requirements are violated.This will be discussed in a subsequent section.

8These statements will be understood after reading the subsequent section on the arbitragefree valuation of CDS.

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impact of trades on the price. Of course, these components are interrelated.Secondary market trading of debt (corporate, agency, municipal) is notoriouslyilliquid (see Chen, Lesmond, Wei [11]). Consequently, bid/ask spreads are largewith correspondingly large liquidity risk premiums.

For the remainder of this paper, we take these debt markets and their equi-librium prices as given.3.1.2 CDS MarketsAs defined earlier, CDS are derivatives written on these primary debt assets.Since CDS are insurance contracts we know from the economics literature that,temporarily ignoring counterparty risk in the execution of CDS, the trading ofCDS is welfare increasing. This is because CDS facilitate the optimal allocationof risks across the economy.

There has been a concern expressed in the literature (see Stulz [49])that thetrading in CDS will destroy the primary market equilibrium under asymmetricinformation with moral hazard and monitoring costs. The concern is that giventhe primary debt holders can insure their lending using CDS, they are no longerconcerned about monitoring the firm's management. Hence, they will not bewilling to incur the monitoring costs thereby unraveling the equilibrium. But,this is a partial equilibrium argument. It takes the CDS market as exogenous.Expanding the equilibrium to include trading in the CDS, the cost of the CDS(insurance) must be included. For the CDS sellers to provide fair priced in-surance, they will need to incur the monitoring costs. The resulting expandedequilibrium will be similar to the primary market equilibrium, with the excep-tion that the reduction in market imperfections should reduce the equilibriumborrowing costs.

With respect to the allocation efficiency of CDS, it is useful to be morespecific and provide some direct examples concerning the benefits of tradingCDS. For financial institutions that originate a large quantity of loans with aparticular geographic or industry concentration, the ability to hedge the creditrisk of these loans by purchasing a CDS enables the financial institution toeliminate the geographic or industry concentration from their portfolio. Cor-porations with significant counterparty risk in their supplier or purchaser rela-tionships can partially hedge the risk of their suppliers or purchasers going outof business by buying CDS. Also, corporations operating in foreign countriescan partially hedge their foreign investment risks using CDS on sovereigns. In-deed, if their profits suffer significant losses in the event of the foreign country'seconomy failing, a CDS provides partial insurance for these losses. These arejust a few of the possible uses of CDS. For other uses, see the ISDA website(http://www.isdacdsmarketplace.com/about _ cds_market).

Perhaps the most important advantage of trading CDS is that it enablesthe buyer of a CDS to short the underlying debt issue without incurring largetransaction and liquidity costs. To understand why this is the case, we first notethat buying a CDS is equivalent to selling the reference debt plus buying anotherwise equivalent Treasury security. Indeed, when buying the CDS one pays

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premiums and receives a gain if the debt defaults. Equivalently, when shortingthe debt and buying Treasuries one pays the spread to Treasuries (premiums)and receives a gain if the debt defaults. This statement is just a restatementof the equivalence between risky debt and riskless debt plus selling a CDS thatwas discussed in the previous section.

Although shorting debt without CDS is possible, it is a very costly exercise.As noted earlier, the secondary trading of debt is very illiquid. To short a debtissue, one needs to be able to borrow the debt issue from a second party, and sellthe debt to a third party. The borrowed issue is returnable upon demand. Inthis procedure, all three "legs" of this transaction incur significant transactioncosts.

Alternatively, one can short the debt by entering a reverse repurchase agree-ment with the debt as the underlying collateral. A repurchase agreement hasa term (usually short). In this reverse repurchase agreement, you receive thedebt as collateral for a loan given to the owner of the debt for the term of theagreement. The amount of the loan is the market value of the debt. At theloan repayment date, the loan is repaid plus interest, and the debt collateral isreturned. To short the debt, you enter into this reverse repurchase agreement,and sell the debt to a third party. Of course, you need to buy it back before therepurchase agreement expires. Often, the interest received on the loan is belowcomparable market rates, since the repurchase agreement is associated with aspecific debt instrument. This is also a costly method of shorting debt.

Thus, in addition to the optimal allocation of risks, CDS remove market im-perfections thereby increasing the efficiency of the debt markets. In particular,CDS enable the more efficient shorting of outstanding debt issues. When shortsale restrictions are imposed or shorting is a costly exercise, market prices canbecome distorted and price bubbles created. This is because negative opinionsconcerning the debt's promise to repay cannot as easily impact the price (seeHong, Scheinkman and Xiong [21]). With less distorted prices and lower trans-action costs, the trading of CDS increases the supply of capital to the primarydebt markets, thereby decreasing borrowing rates, and increasing aggregate in-vestment. This generates a positive real effect on the economy's growth.

However, these welfare increasing benefits were conditioned on no counter-party risk (failure) in the execution of the CDS contracts. When the seller of aCDS contract can fail, many of the welfare properties disappear. Counterpartyrisk is handled via the use of collateral and lines of credit, the lines of creditbeing determined partly on the counterparty's equity capital. This is the issueto which we now turn.

3.2 Collateral and Capital RequirementsCollateral and capital requirements are the analog of capital determination forinsurance contracts. These requirements are mostly designed to reduce or elim-inate counterparty risk with respect to the seller of the CDS. The seller of theCDS is analogous to an insurance company. In this regard there is a tradeoff between percentage collateral posted by the seller of a CDS and the equity

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capital supporting the relevant financial institution.To understand this trade off, let us consider a CDS contract between bank

A, the seller (insurer) and bank B, the buyer (insured).

3.2.1 100 Percent CollateralFirst consider the case where the seller of the CDS, bank A, posts 100 percentof the notional value in collateral. Bank B is the buyer. Let us further supposethat the collateral is held by a trustee in riskless securities and that the risklesssecurities are marked-to-market to guarantee that the notional value is main-tained. In this case, there is no seller counterparty risk to the insured, bank B.lf bank A defaults, then the collateral covers the notional. There is no need toimpose any restrictions on bank A's equity capital.

In this circumstance, one would not want to impose a 100percent ofnotionalcollateral requirement on the buyer, bank B. Bank B is really liable for only thepresent value of the contract. The present value of a CDS contract is only asmall percentage of the notional (e.g. at origination, the present value of aCDS is zero). To eliminate bank B's counterparty risk, bank B should postcollateral equal to the present value of the total premium payments remainingover the life of the CDS (assuming all payments are made with probability one).This is easily computed using Treasury forward rates and the CDS premiumsat initiation. In this situation, bank B's equity capital is also irrelevant.

In this case, both bank A and B hold sufficient collateral to cover 100 percentof their respective promises with probability one. For bank A this represents100 percent of the notional value of the contract, for bank B this represents 100percent of the present value of the remaining CDS premiums.

3.2.2 Zero Percent CollateralAt the other extreme is zero percent of notional in collateral for both bank Aand B. This is the direct analogue of an insurance company selling insurance,supported only by its equity capital. The seller of the CDS, bank A, is the"insurance company." In this circumstance, the equity capital of bank A mustbe sufficient to reduce the probability of failure of the CDS to some acceptablelevel, say to an a percent probability of failure over the life of the CDS. This isa value-at-risk (VAR) type constraint. In this case, bank A's equity capital isthe only cushion to support bank B's losses in the case of contract failure.

The problem with a zero percent of notional collateral and using such a VARconstraint is that VAR measures are very difficult to compute. This is becauseVAR depends on the entire asset and liability position of the bank. Unless oneeffectively posts 100 percent of notional value collateral, it will be impossible toset the probability of a CDS seller's failure to zero.

An analogous equity requirement would need to be placed on bank B, butfor reasons discussed earlier, this is much less onerous.

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3.2.3 0 < 6 < 1 Percent CollateralThis case is in between the previous two extremes. This corresponds to thecurrent market structure. In this case, the 6 percent of notional collateral servesas a cushion for counterparty risk losses but they do not exclude them. Thecomputation of the VAR constraint will be no easier to compute than in thezero percent of notional collateral case.

3.3 ValuationValuation of CDS is the analog of premium determination for insurance con-tracts. To value CDS, one takes as given an equilibrium in the competitiveprimary debt market under asymmetric information as discussed above. Thearbitrage free pricing methodology is employed, usually assuming no marketfrictions and no restrictions on trade. However, both of these perfect marketassumptions can be relaxed (see for example, Broadie, Cvitanic and Soner [9],Cuoco and Liu [14], and Cetin, Jarrow and Protter [10]). The advantage ofthis approach is that one can price CDS without explicitly characterizing theequilibrium in the economy.

Under the assumption of no arbitrage, there exists a risk neutral presentvalue operator that can be used for valuing CDS. The risk neutral present valueoperator depends on the assumed processes for the debt default time and recov-ery rate in the event of default. For implementation purposes, the risk neutralpresent value operator's parameters can be estimated using only market prices.

There are two arbitrage free approaches that can be used to value CDS:the structural and reduced form models (see Jarrow [25] for a review). Thereduced form models are most consistent with the asymmetric information -adverse selection and moral hazard - present in debt markets, and hence, themost relevant for generating CDS market prices. Under reasonable structures,very simple formulas for the CDS premium can be obtained. For academicstudies performing this estimation see, for example, Jarrow and Yildirim [31]and Longstaff, Mithal and Neis [36].

At present, the application of arbitrage free pricing to CDS assume thatthere is zero risk of counterparty default. However, given the emphasis of thispaper, we recognize that this assumption needs to be relaxed. It can be relaxedusing the methods of Jarrow and Turnbull [30]and Duffie and Huang [15]. Thisextension, however, awaits subsequent research.

Statistical studies of CDS spreads confirm a decomposition ofCDS premiumssimilar to that for insurance premiums including the expected loss, a defaultrisk premium, asymmetric information monitoring costs, and a liquidity riskpremium (see Berndt, Jarrow, Kang [5]).

3.4 RegulationRegulation of CDS markets for fraud is a necessity and not discussed further.The purpose of this section is to discuss the need for regulating non-fraudulent

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failure in the CDS markets. Regulation is needed because the welfare increasingbenefits of CDS due to the efficient allocation of risks disappear when CDS sellerfailure occurs. This is because the insured risks are not hedged, after the fact,and the insurance premium was paid for no reason. Regulation is thereforeneeded to control this risk of individual contract failure. In addition, there isalso a negative externality associated with the possibility that massive failuresof CDS could result in a collapse of the financial system. To the extent that thisis possible, regulation is also needed to present such a catastrophe. We elaborateon both of these statements with respect to various regulatory structures.

3.4.1 Current Market StructureFirst, let us consider the current situation, where there is bilateral trade in anover-the-counter market. In this case the seller of a CDS posts only a percentof the notional in collateral, greater than or equal to zero but strictly less thanone. And, Basel II based regulations impose a VAR constraint on the seller'sequity capital. In these markets, the computation of equity capital for CDSsellers is different in three respects from the computation of equity capital forinsurance companies.

First, in contrast to traditional insurance events (e.g. life, car, home owners)which are i.i.d. in each time period and across time, this is not the case for creditdefaults. Default events are not independent across firms (credit entities) andthe likelihood of default for a single firm is correlated across time. Since theeconomy is constantly changing, there is not a long historical record on similarfirms defaulting. This implies that the VAR computation will be more complexthen it is for insurance companies and subject to considerable error.

Second, this non i.i.d. behavior of defaults implies that the law of largenumbers will not apply period by period. Consequently, the expected lossesto a large pool of CDS will differ significantly from their realized losses withpositive probability. To account for this greater uncertainty, CDS sellers willneed to hold significantly more equity capital than an equivalent notional sizedstandard insurance company using the same VAR level.

Third, and perhaps most important, there is correlation in defaults condi-tional upon the health of the economy, which leads to the notion of systemicrisk. When the health of the economy is good, default correlation is less. Whenthe health of the economy is bad, default correlation increases.

It has been argued" that due to systemic risk, if a significant number ofdefaults occur, the failure of outstanding CDS could induce a failure of thefinancial system (see Litan [35],Stulz [49],Duffie, Li and Lubke [16]). A failureof the financial system would have dramatic consequences for societal welfare,perhaps even causing a collapse of the political system. The trading of CDS,therefore, in an extreme case generates a catastrophic negative externality to theeconomy. As an externality, this cost is not included in the pricing of CDS norin the collateral and capital determination. Of course, negative externalities

9See CNNMoney.com, March 16, 2009, "The truth about credit default swaps," C. Barr.

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destroy the Pareto optimality of symmetric information competitive marketequilibrium allocations (see Varian [52], chapter 7).

If these negative externalities exist, and they are yet to be proven, then thisgenerates another role for government regulation of the CDS markets. Ifproven,equity capital needs to be increased to "internalize" the cost of the negativeexternality due to the failure of the economic system. Obviously, quantifyingthe increase in equity capital necessary to accommodate this negative externalityis a nearly impossible task. For this reason, an alternative collateral and equitydetermination system may be preferred.

3.4.2 100 Percent Collateral StructureA simple alternative market structure to eliminate all counterparty risk in thetrading of CDS and, therefore, the negative externality of systemic risk andmarket failure, is to impose the 100 percent collateral condition discussed inthe previous section. It is easy to implement with no intrinsic computationaldifficulties. Of course, the disadvantage of this structure is that the capitalrequirements are onerous relative to the current situation. Although CDS trad-ing activity would certainly be reduced under this structure, it would not beeliminated. 10

3.4.3 Ban Naked CDSThere has been proposals calling for the banning of "naked" CDS trades.l 'Naked CDS trades are buyers of CDS that do not hold the underlying bond. Theidea is to restrict trading in CDS to only hedgers, and to disallow speculatorsfrom taking bets on the credit risk of the reference credit. As noted earlier,buying CDS is equivalent to shorting the debt and investing the proceeds inriskless Treasuries. As such, it is a negative position in the credit risk of theunderling reference credit.

This is the often heard argument that shorts should be restricted becausethey move prices negatively and away from fundamental values. In fact, al-though the theory and evidence supports the position that short sale restrictionsincrease prices, in contradiction short sale restrictions move prices away fromfundamental values creating price bubbles that distort economic efficiency inthe allocation of capital (see Hong, Scheinkman and Xiong [21], J arrow , Protterand Shimbo [27], [28]).

With respect to the issue ofthe failure ofCDS, this restriction has no impacton the equity capital of the sellers of CDS (the insurance providers) whosefailure generates the welfare loss. Consequently, from our perspective, it is amisdirected proposal.10This statement is based on the observation that in reinsurance markets reinsurance con-

tracts are traded by institutions that have a 100% collateral requirement.11See Bloomberg.com, July 24, 2009, "Banning naked default swaps may raise corporate

funding costs," D. Kopecki and S. Harrington, and Bloomberg.com, March 11, 2010, "Nakedswaps crackdown in Europe rings hollow without Washington," B. Mosinsky and A. Kirchfeld.

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3.4.4 Exchange Traded CDSAnother proposal is to have most CDS be exchange traded, 12 where the exchangemonitors both the collateral and the equity capital of the CDS sellers and buyers(see Litan [35], Stulz [49],Duffie, Li and Lubke [16]). Exchange trading has thebenefit of standardized CDS contracts trading at lower transaction (liquidity)costs with increased monitoring of the collateral and capital positions of theCDS counterparties. The collateral investments will be segregated and held insafe (riskless) securities. In addition, there will be more transparency in thepricing and trading activity of CDS. All of these are positive changes.

If the collateral posted as a percentage of notional is increased but is stillless than 100, this moderates CDS seller failure and the likelihood of a financialsystem collapse, but it will not eliminate these events. The negative of sucha proposal is that the restrictions may not be onerous enough to reduce theprobability of failure to an optimal level from a societal perspective, includingthe negative externality related to financial system collapse.Another alternative, not being considered, is to have the exchange tradedCDS transformed to futures contracts, where daily gains and losses on the con-tracts are paid each day using a margin account. If this occurs, then appropri-ately determined margin requirements will virtually eliminate both CDS sellerfailures and the likelihood of financial system collapse for exchange traded con-tracts.

Also, not all CDS can be exchange traded if there is a need to customize theinsurance contract. Trading in these customized over-the-counter CDS, whichare important for the efficient allocation ofrisk in the economy, are not addressedin this proposal. One solution is 100 percent collateral for these customized CDScontracts. A second is executing all over-the-counter customized CDS througha central clearing counterparty (CCP).3.4.5 CCP TradingAn intermediate trading structure between over-the-counter (bilateral) tradesand exchange traded CDS is using a central clearing counterparty (CCP), seeSingh [42], Duffie and Zhu [17], and Duffie, Li and Lubke [16]. The centralclearing counterparty would stand between all trades in an attempt to guaran-tee execution. Although trades need not be standardized, collateral would besegregated and held in safe assets. In addition, collateral requirements wouldbe higher. Netting across common counterparties mayor may not be allowed.Transparency in pricing and trading activity would also be less than that withan exchange.

With respect to CDS seller failure risk, it would be reduced, but not elimi-nated by this market structure.12See Bloomberg.com, July 24, 2009, "Banning naked default swaps may raise corporate

funding costs," D. Kopecki and S. Harrington, Wall Street Journal, March 11, 2010, "Wallstreet mobilizes to shape look of CDS rules," M. Gongloff, Wall Street Journal, April 14, 2010,"Banks fight to block rules," S. Lynch.

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Currently, there are a few clearinghouses already clearing CDS trades: theICE Trust and the CME Group. Although operational, they have not clearedsignificant volume as of yet (see Litan [35],p. 23).

4 The 2007 Credit CrisisConsistent with the emphasis of this paper, this section studies the 2007 creditcrisis as it relates to the trading of CDS. We restrict our discussion to only thissmall component of the economic crisis. More comprehensive treatments of thecredit crisis have been written, see for example Crouhy, Jarrow, Turnbull [13].

What went wrong in the crisis related to CDS? Effectively, there was toolittle economic capital in the system to cushion the credit losses associated withthe CDS trading in the economy.

Rating agency error in evaluating default risk was a key factor in there beingtoo little equity capital. This misevaluation of risk generated two distortions inthe determination of equity capital. One, it enabled highly rated firms to sellCDS with little or no collateral and very little equity capital. Two, it generatedrisky AAA rated securities with high yields, against which little equity capitalwas required. Both of these distortions lead to excessive risk taking withoutadequate capital and eventually excessive losses.

4.1 Direct CDS PortfoliosPrior to the credit crisis, various financial institutions were created to purchase"diversified" pools of CDS. Quotes are placed around diversified because due tosystemic risk, i.e. default contagion, these pools contained systematic defaultrisk. This included a division within AIG (see Congressional Oversight JuneReport [12])) and various derivative product companies (see S&P [47]). Forthese investments to be profitable, a high rating for the company was a necessitybecause highly rated firms needed to hold little if any collateral against theirCDS positions. And, capital is costly (a large opportunity cost for alternativeinvestments) .

Due to a miscalculation of the risk of a portfolio of CDS, the rating agencieshighly rated these companies. Recall that a CDS is equivalent to buying a riskbond and shorting Treasuries to get the financing. Hence, these were highlylevered portfolios. Due to their high rating, little or no collateral and insufficientequity capital was required.

Prior to the default contagion associated with the credit crisis, these com-panies received significant cash inflows (the premiums) with little or no cashoutflows (losses paid). They were very profitable, and their business model wasbelieved (falsely) to represent an arbitrage opportunity. However, when thecrisis hit and the CDS losses exploded, the equity capital cushion disappeared,leading to insolvency (e.g. AIG's bailout).

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4.2 Indirect CDS PortfoliosPrior to the crisis, many commercial banks, investment banks, hedge funds,pension funds, etc. indirectly created large "diversified" pools of CDS. BearStearns being the most visible example+'. These pools of CDS were indirectlycreated in the following manner. Due to the misrating of various bonds issuedby collateralized debt obligations (CDOs), these risky bonds had AAA ratingsand high yields. They appeared to be attractive investments and they were pur-chased in large quantities. To increase their returns, many of these institutionsborrowed to invest resulting in very little equity capital.

The resulting balance sheet of such a financial institution is effectively equiv-alent to a portfolio of CDS. Recall that buying risky debt and shorting Treasuries(borrow at low rates) is equivalent to selling a CDS.

As with direct CDS portfolios, prior to the credit crisis these companies werevery profitable. However, when the crisis hit, significant losses were realized.

5 ConclusionItis widely argued in the financial press that CDS represent an "evil temptation"for financial institutions and that they caused the financial crisis. Consequently,trading in CDS needs to be eliminated or severely controlled. These beliefs aredistortions of the truth.

Contrary to these negative allegations, trading CDS is good for the economy.CDS being analogous to insurance contracts, have positive real effects on theeconomy. Trading CDS increases the efficient allocation of risks in the economyand they remove price distortions caused by various market imperfections inthe shorting of risky debt. Combined these benefits decrease borrowing costsfor productive investment opportunities thereby increasing aggregate investmentand economic growth.

Continuing the analogy, CDS being insurance contracts (on default risk),the sellers of CDS (insurance providers) need to have sufficient equity capital toguarantee execution of the contract. Any claims made on the insurance contractsneed to be paid. Unfortunately, due to the misevaluation of the risks of riskydebt by the rating agencies, too little equity capital was held by the sellers ofCDS. Visible examples of this include AIC and Bear Stearns. Consequently,when the contagion of defaults occurred and large claims on the insurance weremade, they could not be paid. Insolvency of the sellers of CDS occurred, andunprecedented losses were realized.

As with insurance company regulation, more government regulation of CDStrading is needed to guarantee that sufficient equity capital supports the sellingof CDS. This could most easily be accomplished by requiring sellers of CDS topost 100 percent of the notional as collateral. This approach has been used forsome institutions in the over-the-counter reinsurance markets for many years.It is surprising that this suggestion has not be made in the financial press.13Businessweek, June 12, 2007, "Bear Stearns' Subprime Bath," Matthew Goldstein.

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Instead, proposals for requiring that all CDS be cleared through a centralclearing counterparty (CCP), or be exchange traded, or that the buying of nakedCDS be prohibited. Although both CCP clearing and exchange traded CDSmoderate the lack of equity capital problem, they do not eliminate it. Banningthe buying of CDS without holding the underlying debt has no impact on theseller's collateral. As such, it has no impact on the equity capital problem, andit is an irrelevant proposal.

Ithas also been alleged, but never proven, that massive failures ofCDS couldcause the collapse of the financial system. If true, then this negative external-ity needs to be "internalized" within the market via government regulation.Quantifying this negative externality will be nearly impossible.

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Years Interest Rate & Currency Credit Default Swaps Equity2001 69,207.30 918.87 NA2002 101,318.49 2,191.57 2,455.292003 142,306.92 3,779.40 3,444.082004 183,583.27 8,422.26 4,151.292005 213,194.58 17,096.14 5,553.972006 285,728.14 34,422.80 7,178.482007 382,302.71 62,173.20 9,995.712008 403,072.81 38,563.82 8,733.032009 426,749.60 30,428.11 6,771.58

Table 1: Derivatives Contracts Outstanding.Notional Amounts in Billions of U.S. Dollars

(source: ISDA Market Survey 2010)

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the economics of cds

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