Naked Credit Default Swaps (CDS) are credit default swaps holdings that are not backed by a sufficient amount of the underlying asset. Holding a naked CDS holding is like getting automobile insurance without owning a car or taking fire insurance on someone else’s house.
Naked credit default swaps allow investors and traders to take positions on assets without actually owning the assets. It greatly increases the size and scope of the market. It is estimated that over 90% of the CDS market consists of naked CDS.
What is a Naked Position?
An investor holding credit default swaps without holding the underlying asset insured by the credit default swaps is said to be in a naked position or an uncovered position (if the investor owned the underlying assets, it would be a covered position). Naked positions allow investors to extend the concept of short-selling to the derivatives market.
Advantages of Naked Credit Default Swaps
A naked CDS is the derivatives equivalent of short selling. Short selling allows an investor to “sell” assets he does not own and “buy” them back at a later date. Therefore, an investor short selling an asset expects the price of the asset to fall. They increase liquidity in the market by reducing lags associated with correct price discovery (i.e., the presence of short sellers reduces the time it takes for the market to accurately identify a mispriced asset).
Therefore, naked CDS increase liquidity in the market for credit default swaps and reduce market inefficiencies caused by mispricing. Proponents of naked CDS argue that the reductions in market inefficiencies actually reduce the risk of a contagion in the broader derivatives market.
Disadvantages of Naked Credit Default Swaps
The primary danger associated with naked CDS stems from its disproportionate size relative to the market for covered credit default swaps. Every buyer in the naked CDS market only needs to be able to pay the premiums associated with the CDS whereas every seller in the naked CDS market needs to be able to back the entire default amount (i.e., the CDS issuer must possess sufficient resources to underwrite the CDS). It leads to the number of buyers vastly outnumbering the number of sellers.
Consider the scenario where the market believes that the Greek government is going to default on its bond payments. It increases the demand for Greek government bonds CDS. The increased demand is associated with an increase in premiums. However, the number of CDS providers is limited due to the capital constraints that need to be met in order to become a CDS issuer.
Such a mismatched market structure potentially increases the likelihood of the underlying bond defaulting. If the market were limited to covered credit default swaps only, the number of buyers would be limited to investors with direct exposure.
Naked Credit Default Swaps and Moral Hazard
Naked credit default swaps raise the issue of moral hazard within the derivatives market. Consider the example described above of owning fire insurance on someone else’s house. The owner of the insurance now has an incentive to set the insured house on fire and profit from the default payout.
Naked CDS create similar issues, albeit on a much larger scale. An investor with a large holding of naked CDS on Greek government bonds could try to harm the Greek government’s image in public in the hope of causing panic and subsequent default of the underlying bonds.