Bank of England Staff Find Good in Swaps the Pope Warned About
Bank of England Staff Find Good in Swaps the Pope Warned About
(Bloomberg) --
Complex instruments used by hedge funds to bet on borrowers going bust and linked to “extremely immoral actions” by the Vatican, can actually improve the health of financial markets, according to Bank of England staff.
Bonds insured by credit-default swaps are likely to trade more frequently than securities not covered by these derivatives, according to research by Robert Czech of the BOE’s capital markets division, published in a blog on Monday. More liquid bonds are easier to sell, which benefits investors at times of market stress.
“In theory, CDS contracts can reduce risks in financial markets by providing valuable insurance,” wrote Czech. “CDS also offer another, more subtle benefit: an increase in the liquidity of the underlying bonds.”
Credit-default swaps have repeatedly come under scrutiny from regulators after being linked to shady deals and because they are widely seen as having contributed to the 2008 global financial crisis. Warren Buffett once called them “financial weapons of mass destruction” while last year, the Vatican released a sweeping critique of global finance that referred to the instruments as “a ticking time bomb.”
“Critics refer to CDS as a global joke that should be outlawed, not at least due to the opaque market structure,” wrote Czech. But those critics may be overlooking some beneficial effects of the CDS market, he said.
Investors with active CDS contracts on a particular firm have 60% higher buy volumes in the issuer’s bonds than non-CDS counterparties, according to the research. Liquidity spillover between the two markets is particularly pronounced around the time of rating downgrades. CDS counterparties increase their buy volumes in bonds of downgraded issuers, absorbing fire sales that come from other investors, he wrote.
Still, criticism of credit swaps isn’t entirely unjustified, Czech wrote. Manufactured credit events, whereby investors make money by enticing companies to miss bond payments they could otherwise make, are a “prominent example” of “questionable practices.”
The post appeared on Bank Underground, a blog that allows staff to share commentary and analysis as part of Governor Mark Carney’s effort to increase transparency.
To contact the reporter on this story: Katie Linsell in London at klinsell@bloomberg.net
To contact the editors responsible for this story: Vivianne Rodrigues at vrodrigues3@bloomberg.net, Chris Vellacott
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