July 30, 2009 4:28PM

The Benefits of Going Naked…Swaps and Derivatives

Key House Democrats have just proposed a new plan for regulating our Nation’s derivatives’ markets. While the heart of the plan mirrors the Obama Administration’s proposal to require standardized derivatives, such as credit default swaps (CDS), to be traded over a centralized exchange, the House proposal also goes further, raising the possibility of banning “naked” positions in the derivatives, equities and debt markets.

Taking a naked position, where one hedges or bets on a specific risk without actually holding the underlying asset or liability, has been widely blamed for bringing down our financial system. This blame is misplaced. For instance, credit default swaps betting that companies such as Fannie Mae, Bear Stearns or AIG would fail did not bring down those companies — bad management practices and excessive risk‐​taking did. Of course when those companies were on the way down, their management wanted to blame everyone but themselves; short‐​sellers and speculators were just the messenger of a truth that management wanted to hide.

At heart, our markets, particularly our capital markets, serve as valuable aggregators of information, generally via the price mechanism. Speculators, including those holding a naked position, help bring new and valuable information to the market place. Recall it was the short‐​sellers who discovered Enron’s frauds, not the regulators or the rating agencies. Banning naked positions will only serve to reduce the information content of market prices, and also further entrench incompetent management.

In addition to the aid in price discovery, speculators also provide much needed liquidity to other holders of the same instruments. For instance if you purchase a GM bond and also a credit default swap on GM to hedge the credit risk in that bond, you would prefer to be able to see that CDS contract in as broad a market as possible. If you were limited to selling that contract only to another holder of that same bond, you will likely have both a harder time selling that contract and will receive a lower price for it. One of the hardest parts of resolving AIG has been finding buyers for its derivatives contracts. A deeper market in derivatives would lessen the potential “fire sales” that can occur when a large financial firm fails. 

Of course how one treats derivatives in the case of an issuer failure can greatly impact the stability of the financial system. By removing derivatives and CDS from the automatic stay provisions of the bankruptcy code in 2005, Congress guaranteed that when a large issuer of CDS got into any trouble, there would be a run on its collateral. The solution is not to ban naked positions, but to reduce the potential for collateral runs by treating CDS counter‐​parties like any other creditor.