In the Atlantic Charles Davi tries to argue that critics of credit default swaps simply don’t understand the market. However, his arguments don’t show that he has a clear understanding of the market himself.
With the CDS market, we have a market-based measure of the credit quality of a wide variety of debt instruments outstanding for a given issuer. This makes the credit quality of an issuer more transparent, not less.
This is incorrect, because every CDS price necessarily includes not just a premium for protection against default by the underlying, but also some premium for the counterparty risk inherent in buying protection on derivative markets. (The existence of negative basis trades where the CDS price is below the rate paid by the bond probably reflects the fact that the CDS market — for the limited group of people who are allowed to trade these high denomination products — is indeed more liquid than the bond market. Note that as far as I am aware, there is neither empirical evidence, nor a theoretic argument that supports the view that more liquid markets produce better prices.) As noted in earlier posts, the only circumstance in which an over the counter derivative does not involve counterparty risk is in the theoretic example where the derivative is written by a monetary authority.
Because CDS prices necessarily confound a premium for protection against default with a premium for counterparty risk, it’s hard to understand the foundation of the argument that CDS prices give a better measure of credit quality than a model based only on the bond yields themselves — which will as rule include no credit risk premia for parties other than the issuer.
However, even if we were to grant the argument that CDS prices give a superior measure of default risk, then that would immediately indicate that price disclosure in the CDS market must be improved. While Davi claims that
the level of publicly available information from the CDS market is on par with that from the corporate bond market
as a small scale trader, I can assure you that this statement is incorrect. I can access intraday corporate bond bids and offers whenever markets are open. Davi links to the only public CDS pricing data that I know of — and this only gives end-of-day prices after the market is closed. If Davi’s argument that CDS prices are “better” than bond prices is correct then the bond market is seriously biased against small traders.
In other words, if CDS price information is as valuable as claimed, then it is inexcusable to restrict access to intraday price and quantity information to insiders like the market making banks and their biggest clients. In short, if the CDS market produces tradable price information, then as Gensler argued it’s time for CDS to trade on exchanges so that intraday prices and quantities can be made public in real time and everybody who trades bonds can benefit from the information created by this market.