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Which Country Has The Largest Percentage Of Governent Debt Due To Net CDS?
Saturday, May 29, 2010, by Stathis
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I've added this question to the website poll to the left, so I want to encourage you to take a stab.

Before you place your vote, I will go ahead and tell you the answer is NOT Greece. So you might want to do a little leg work and see if you can find the answer.

Also, keep in mind that NET CDS refers to the amount of credit default swap contracts (CDS) that are not offset by opposing contracts, so there is a net effect due to the CDS. The problem with this situation is that CDS contracts were created to function as hedges or insurance contracts. 

Thus, when any level of net CDS exposure exists, this implies these derivatives are being used for speculative transactions.

When this speculation targets sovereign debt, financial institutions have the ability to destroy the economies of entire nations. This is clearly a huge problem that remains unaddressed.

If you still don't understand the effects of net derivatives exposure, let me try to explain using an example with options contracts.

Let's say you bought 1000 shares of BP and you wanted to extract some income because you have a bearish posture in the short term, so you write (or sell) 10 call contracts.

This would be considered a fully covered call position since the number of call contracts you sold matches the number of shares you own (each contract represents 100 shares of the underlying stock). There would be no net options exposure in this case, which is why these options are referred to as covered calls.

If however, instead of selling 10 call contracts, you sell 15. In this case, you would have a net exposure of 5 (uncovered or naked) call contracts, representing 500 shares that you don't have. If the stock price closes above the strike price on expiration, you must pay the difference multiplied by 500 since you had a net exposure of 500 shares (your 1000 shares will also be called away).

Of course, you could always buy back the contracts at anytime prior to expiration in order to reduce your losses.

CDS contracts work in a similar manner, as do other derivatives. When you generate net exposure, it can have devastating effects for one party, and spectacular returns for the other party. This is especially true when leverage is used to purchase these contracts (in this case, I am referring to leverage as borrowing money to purchase derivatives).

CDS contracts were never intended for speculation. They were created to protect underlying assets. Of course someone must take the other side of the trade. But it really doesn't become speculation unless you have a net exposure since derivatives have value only up to an expiration date. Furthermore, when leverage is used, it can create huge net derivatives positions. This magnifies the speculative nature of the transaction.  

Perhaps the biggest problem is that only funds and financial institutions get to take part in much of this speculation, and it often comes at the expense of individual investors. Many financial instruments are not available to individual investors because these atypical securities do not trade on public exchanges. Instead, they trade in markets only available to instititions. Brief examples of these restricted securities are MBS, ABS, exotic derivatives like CDS, synthetic derivatives (complex derivatives). There are dozens of additional examples.

The solution is not to provide individual investors with the same abilities to speculate with these financial instruments.

The solution is to prevent everyone from doing so. That means net derivative exposure for certain derivatives such as CDS should be banned. Moreover, investors should be required to pay cash for derivatives tranastions. Since funds can use margin for other securities to generate cash which can be used to purchase derivatives, there should be very strict limits placed on the amount of derivatives that can be bought and sold in leveraged funds.

Too many people have already suffered huge losses. It's time to put an end to these activities once and for all.

Casinos are for speculating. The capital markets are for investing. There is a very big difference. When the distinction between a casino and the capital markets becomes blurred, we have a huge problem.

The combination of leverage with net CDS positions has already disrupted the financial markets, and will continue to pose enormous risks. The use of leverage should never be permitted with derivative transactions unless the fund holds the underlying assets.

Of course, these restrictions will never be implimented because the SEC and CTFC are useless. They often turn their head when informed of major fraud if either the names are too big or the fraud has negative political implications. The latest example of this can be seen from the lack of any effort by the SEC to investigate the massive fraud involved with the Washington Mutual seizure, including (but not limited to) blatant insider trading.

Other times, the SEC targets fraud specifically for the purpose of generating political momentum. 

 

 

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