Repeat after me: CDS are not insurance | FT Alphaville

Repeat after me: CDS are not insurance

Alright, hold it.

In the midst of the ongoing and increasingly heated debate about credit default swaps, be they naked, sovereign or Sharia compliant, one fundamental fact has been overlooked: these instruments are not insurance.

The idea that they are a kind of insurance is one that has gained currency in no small part because of the insistence of the media — including, we admit, this parish — in describing them as “a kind of insurance against default”.

This misunderstanding and mislabeling has led, inevitably, to assertions of the kind epitomised by the following letter to the FT:

Sir, Further to Wolfgang Münchau’s column “Time to outlaw naked credit default swaps” (March 1), I would note that at the core of the naked CDS is something that has been illegal for more than three centuries.

In 1746, the UK parliament passed the Marine Insurance Act, requiring anyone seeking to collect on an insurance contract to have an interest in the continued existence of the insured property. Thus was born the insured-interest doctrine. The indemnity doctrine, which precludes a buyer from insuring property for more than it’s worth, soon followed.

The point of these rules is to limit insurance contracts to trading existing risks and not to create risks by giving buyers of insurance incentive to destroy property. The doctrines have been part of insurance law in both England and the US (which in 1746 were colonies under English common law) ever since.

Matthew Saroff,

Owings Mills, MD, US

Pardon the tautology, but if Mr Saroff’s assertion were true, he would be right.

But credit default swaps are not an insurance contract, and therefore, do not at all require an insurable interest in the reference entity.

Here is an extract from a FAQ by SIFMA — the Securities Industry and Financial Markets Association — on the matter:

In this respect, CDS are like all other derivatives (listed and unlisted) that do not require the incurrence of a loss as a condition to payment under the derivative instrument…the absence of any requirement that a CDS holder incur a loss as a condition to payment is critical to the efficiency of, and the benefits afforded by, the CDS market. Because CDS do not require an insurable interest, or the incurrence of a loss as a condition to payment, if treated as insurance, they would be prohibited as a result of the very feature that has contributed to the success of this product.

Whether CDS should require an insurable interest– i.e. the debate around naked swaps — is a different matter entirely.

And if you’re interested in that discussion, you could do worse than to refer to any of the links below:

In the camp to ban naked and/or sovereign CDS – Willem Buiter, Wolfgang Münchau, US politicians, Greek politicians, French politicians, Portuguese politicians, various FT letter writers.

Somewhere in the middle – David Merkel.

In favour of the right to go nude – Sam Jones, Charles Davi and Craig Pirrong, Moorad Choudhry (and again), various FT letter writers, investment banks, hedge funds.

Draw your own conclusions – just don’t call ’em insurance.

Related links:
Sovereign CDS: Oh the irony of it all – FT Alphaville
Naked CDS: Exposed – Derivative Dribble