Tuesday, June 30, 2009

Buying CDS protection could be prohibited

From Epitome Weekly
The climate-change bill passed by the U.S. House would expand federal regulations by banning "naked" credit default swaps (CDS) and requiring over-the-counter (OTC) derivatives to go through central clearinghouses. Further it directs the Commodity Futures Trading Commission to set position limits on energy traders across all markets and brings energy swaps under CFTC oversight. The CFTC is the futures market regulator.

CDS instruments were censured for amplifying last year’s credit turmoil. The steep decline in financial markets prompted proposals for tougher federal regulation. Some of the proposals in the climate bill, such as mandatory clearing of OTC derivatives, are part of the Obama administration proposal for financial regulatory reform. A bill pending in the House allows suspension of trading in "naked" CDS, but would not ban them outright.
Looks like some politicians snuck something into the climate-change bill that doesn't belong (we will discuss the the climate-change bill and cardbon trading later.) Not clear what is meant here by banning "naked" credit default swaps. Certainly writing protection without posting margin is a problem. But buying protection on a name that one doesn't actually own shouldn't be an issue.

People get annoyed hearing this because it feels like buying insurance on a house you don't own. But this is no different than buying a put option on IBM without owning any IBM shares. Except CDS is a put on credit rather than equity. Are we so far gone that we will allow the government to potentially prohibit us from buying put options? Pathetic.

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