Naked Credit Default Swaps

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What Are Naked Credit Default Swaps?

Naked credit default swaps refer to a situation where an investor who does not hold a direct financial interest in the underlying debt obligation purchases a credit default swap (CDS). In other words, the buyer of a naked CDS does not own the bond or loan being insured.

Naked Credit Default Swap

Naked CDS is primarily available for corporate and government bonds. Investors may use it to speculate on the creditworthiness of a particular company or government entity. If the entity defaults, the investor can profit from the CDS payout without owning the underlying debt. Investors typically employ this strategy with a high risk tolerance to benefit from potential credit events.

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  • Naked credit default swaps are derivative instruments where the buyer and seller take opposite positions on the credit default status of a government or corporate bond.
  • The distinguishing factor is that neither party holds an underlying asset or has an insurable interest in the referenced securities. Instead, they engage in speculative betting on the creditworthiness of the bond.
  • Ethical and moral concerns have been raised regarding naked CDS due to their speculative nature and potential impact on financial markets. These concerns have led to regulatory changes to increase transparency and oversight in the derivatives market.

Naked Credit Default Swaps Explained

Naked credit default swaps are major derivative contracts and form the majority of CDS contracts. Let's begin by understanding CDS.

Credit default swaps are insurance instruments that enable creditors to protect themselves from credit default risk by transferring it to third parties, known as CDS sellers. For this, the buyers pay a premium to sellers. If the borrower defaults, the seller will compensate the buyer for their loss.

Naked CDS does not have an underlying asset. Instead, it replicates the movements and fluctuations of other assets. It is the main difference between a CDS and a naked CDS. In the latter's case, the asset is primarily corporate and sovereign bonds.

A naked CDS is a contract between a buyer speculating that the company or government will default and a seller betting the opposite. Like a CDS, the buyer pays the seller a monthly or annual premium for insuring their bet. From the buyer's perspective, the bond issuer should default. From the seller's perspective, the issuer should not default.

Hence, there are two scenarios:

#1 – The issuer defaults

It is a win for the buyer. They will receive compensation equivalent to the size of the corporate or government debt raised through the bond issue. Their only loss would be the premium payments made to the seller until the company defaulted.

#2 – The issuer doesn't default

It is a win for the seller. They need not pay a sizeable amount to the buyer and can keep receiving the premium payments until the CDS expiry.

The buyer stands to gain more. Consequently, there are more CDS buyers than sellers. Further, most naked CDS contracts have a longer expiry as the probability of default is less than 12 months. Most naked CDS contracts last at least five years.

Examples

let us refer to the following examples to understand naked CDS better.

Example #1

Here's a hypothetical example. Investor A is a CDS buyer speculating that company PQR will default on its 2023 bond payments worth $1 million. Investor Z is a CDS seller betting that the company will not default. Investors A and Z enter into a contract. Investor A makes monthly premium payments of 100 basis points (1%) to Z, i.e., $10,000.

It hopes that the company defaults, so it gets $1 million and only incurs a loss of $120,000. Investor Z hopes the company doesn't default, as they would make $120,000 by the end of the year. Otherwise, they would have to pay out $1 million. The size of the risk is understandable from this example.

Example #2

In 2011, the European Union banned any trading activities involving naked CDS citing risk, morality concerns, and their influence on the financial market. While some favored the instrument, the criticisms against it were severe. Market experts and financial analysts expect the same fate to befall CDS.

CDS does not have as many ethical concerns as its naked counterpart. The investor takes a CDS to insure their investment and not others. However, their degree of influence on the market is a concern, especially regarding government and corporate bonds.

Advantages And Disadvantages

Let us understand the pros and cons of naked CDS.

Advantages

  1. Naked CDS helps enhance liquidity in the market. CDS investors are speculators looking to make short-term profits. Short selling is one method they resort to. It increases the frequency of transactions in the market, thus increasing liquidity.
  2. Naked CDS is suitable for investors looking to hedge their investments. While the degree of risk is high, the rewards are promising. Traders with high-risk tolerance can opt for naked CDS.
  3. The instrument allows the market to identify asset mispricing and correct market inefficiencies. The argument is that the high frequency of transactions and higher speculative activity leads to an automatic correction of the asset's market price.
  4. It serves as a measure of credit risk. Naked CDS contracts involve a buyer and seller betting on a payment default. The instrument can accurately show how many people have defaulted in a particular region in a specific timeframe.

Disadvantages

  1. Moral sentiments against naked CDS are rising as it is possible to profit enormously from an asset one doesn't even hold. While this is possible with other derivatives, such as futures and options, the underlying size is the concern.
  2. Naked CDS buyers pay a premium to sellers. For buyers, it is the payment of monthly installments. But for the seller, it is one lump sum payment of thousands of dollars if the credit defaults. It automatically leads to an imbalance in the market as there is a disproportionately high number of buyers compared to sellers.
  3. There is a thin line between holding a naked CDS and gambling. It is based on a contingency – an event that may or may not happen. Therefore, some traders might go beyond and try to make the contingency in their favor so that they would make a profit.
  4. Naked CDS holders do not have an insurable interest in the asset, i.e., any benefit or loss related to the asset does not affect the investor. Critics in the market question why anyone should be allowed to trade on an investment with no insurable interest. This question laid the foundation for many countries banning naked CDS.

Frequently Asked Questions (FAQs)

1. Are naked credit default swaps solely used for speculation?

While naked credit default swaps are often associated with speculation, they can also serve legitimate risk management purposes. Some investors use CDS contracts to hedge against potential default events and protect their portfolios. However, the speculative nature of naked CDS has raised concerns about their impact on market stability.

2. How are naked credit default swaps different from traditional CDS?

The critical difference between naked CDS and traditional CDS lies in the ownership of the underlying debt obligation. In a regular CDS, the buyer typically owns the debt instrument being insured. In contrast, a naked CDS buyer does not hold a direct financial interest in the underlying debt obligation and is speculating on the entity's creditworthiness.

3. Are naked CDS banned or restricted?

The regulation of naked CDS varies by jurisdiction. In some cases, they have been banned or restricted due to concerns about their impact on market stability, speculation, and ethical considerations. However, naked CDS regulations and restrictions can differ among countries and financial markets.