Wednesday, October 19, 2011

Ban on naked CDS

The European Union has decided to impose a ban on naked CDS - i.e. betting on the default of a sovereign government where there is no existing risk to be covered. They have decided that this type of betting is harmful to their economy. It is a recognition that these financial products are designed mainly for betting, and cause harm rather than good.

4 comments:

Anonymous said...

The next step is to ban naked short selling.

i.e. where the number of shares shorted exceed the authorized issued share capital of the shorted company.

Simon said...

Could someone explain what is "naked CDS". I read the article but it does not explain the term.

Thank You

Koh Lip Wee said...

Hi Simon,

Wikipedia has an excellent article on this.

http://en.wikipedia.org/wiki/Credit_default_swap#Naked_credit_default_swaps

Retail investors should avoid these Derivatives Products (DP). The use of DP should only be confined to experienced specialists (e.g. proprietary trading or corporate hedging and arbitrage strategists etc). They are not suitable for mass retail market.

Lip Wee

SimplyTerror said...

I totally agree with Lip Wee above, though I doubt CDS's is an instrument available to most retail investors.
I disagree with a ban on shortselling though. If short sales are disallowed, then the market prices would be driven by investors with the most optimistic views on market performance. Investors with less optimistic (or perhaps, more rational) expectations would be left out of the market. End result, market bubble.
On the other hand, when short selling is allowed, whenever market prices are too high and rational investors recognise this, they could short the asset in question, increasing supply and driving prices down, towards a more 'rational' level.
And just to clarify the first commentator's definition of naked short, that's when a market participant has sold an asset short without first 'borrowing' the asset from a third party to cover his position. I think the risk of naked shorts is more to do with inability to fulfill delivery requirements than anything else.

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