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Thursday, August 4, 2011

The essential legal distinction between CDS and 'credit insurance'.

During the subprime crisis, some investment banks who purchased CDS from 'professional counterparties', were accused of using insider information on the underlying security's credit risk(from the commercial/investment banking side). The implication was that by not disclosing the conflict of interest/insider information, the banks were able to purchase CDS at lower prices, which they then profitably exited around the time of the subprime crisis.

Now, CDS is essentially a bet that the security will default. And credit insurance is pretty much the same thing(economically). The crucial difference between insurance and put option is that
  1. Insurance, in most cases, covers only actual loss and also known as 'contract of indemnity'. But in case of CDS/put options, the person purchasing protection need not physically own the security.
  2. To solve the perennial information asymmetry problem, insurance laws deem insurance to be a 'contract of utmost good faith' and mandate full disclosure of all risks.  But in financial products, unless the bank is deemed to owe a fiduiciary duty to its client/counterparty(which all banks invariably disclaim to the fullest extent allowed), they are not subject to such fair dealing norms. And regulators consider these players to be 'big boys' not in need of such protection
  3. In CDS, one can hedge partially without penalty but in insurance, there are penalties for under-insurance where the average clause is applied. 
Hence, before accusing the CDS buyers of sparking moral hazard etc, it would be good to know that different structures have varying obligations despite having the same economic consequences. Another example of regulatory arbitrage maybe.

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