Another Troublesome Feature of CDS Usage

By Marti Subrahmanyam Charles E. Merrill Professor of Finance, Economics and International Business & Pablo Triana

The recent Greek debt restructuring illustrates how the empty creditor phenomenon may lead some players to attempt to derail a debt workout highly beneficial to the entity, and to its ordinary (i.e., non CDS-holding) lenders.

Credit default swaps have been controversial almost since they were first conceived about 15 years ago. Many have argued that the contracts lack clarity and are open to arbitrary interpretation. Others complain that CDS prices are not a reliable indication of real credit risks. Post-crisis, regulators have agreed about the opacity of the market, demanding that CDS be registered and traded through clearing houses.

The truly troublesome feature, though, has to do with the “empty creditor” problem. Empty creditors are lenders (to a corporation or government) that cease to be concerned about whether the borrower fares well or poorly. Their interests are not aligned with those of other creditors, who prefer that the debtor does well, so that the debt is repaid.

Bond or loan holders using CDS to gain credit protection qualify as empty creditors: if the borrower gets into trouble, the CDS, if triggered, would cover any losses on the underlying position; if the borrower honours its obligation, the investment is made whole (minus the cost of the CDS protection). In a more extreme scenario, the empty creditor may benefit even more by “over-insuring” – purchasing a proportionately larger amount of CDS protection than the debt owned (there is no real limit on the amount of CDS “protection” investors can buy). Obviously, those who did not enter into CDS are not indifferent to bad news as they have a more asymmetric pay-off.

Read full article as published in the Financial Times.