Author Archives: media.comment

Post hoc, ergo propter hoc

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After this, therefore because of this.  

Students of Latin (and devotees of the The West Wing TV show) know that the phrase above describes a common logical fallacy. One thing does not (and can not be said to) cause another simply because it came first.

The current debate over rising commodity prices brings this thought to mind.

As several recent articles have noted (including these from The Independent and the Financial Times), there has in recent years been an increased flow of investment funds into commodities. Commodity prices have experienced volatility and price changes during this time.

This has raised concerns that the “financialization” of and increased financial speculation in these markets are adversely impacting them. One thing (increased investment) leads to the other (higher prices), at least in the minds of some.

Given its importance, there have in recent years been a number of research studies conducted by leading academics and government institutions into this issue. What does the research show?

As Professor Craig Pirrong of The University of Houston has written, “As yet there is no serious theory, and certainly no serious evidence that speculators have distorted commodity prices.” In addition, a US CFTC Commissioner — Michael Dunn — stated in 2011, “To date, CFTC staff has been unable to find any reliable economic analysis to support either the contention that excessive speculation is affecting the markets we regulate or that position limits will prevent excessive speculation.”

In fact, there is today abundant evidence that supports the view that speculation makes little, if any, difference to food prices and price volatility:

Criticism of “speculation” and “financialization” might be timely and trendy, but it’s important to base policy decisions on the facts.  As ISDA has written:

“Although speculation is often blamed for causing problems in markets, the economic evidence shows that it is in fact a necessary activity that makes markets more liquid and efficient, which in turn benefits hedgers, investors, and other market participants.  Speculation increases market liquidity by reducing bid-offer spreads, by making it possible to transact more quickly at a given size, and by making markets more resilient.  Speculators make markets more efficient by helping move prices closer to fundamental values: short sellers, for example, provide discipline against overpricing while speculative buyers counteract unjustified drops in price.  Without speculation, markets would be less complete in that there would be fewer opportunities for other market participants, especially hedgers, wishing to manage the risks they encounter in their financial activities.”

The potential adverse impact is echoed in the academic literature. An EDHEC-Risk Institute paper notes that “proposals to restrict speculation fall somewhere in the continuum of being a placebo to actually being harmful to the goals to which they aspire.”

In addition, the Irwin-Sanders paper states:  “the policy implication of the available evidence on the market impact of commodity index funds is straightforward: current regulatory proposals to limit speculation — especially on the part of index funds — are not justified and likely will do more harm than good…. The net result is that moves to tighten regulations on index funds are likely to make commodity futures markets less efficient mechanisms for transferring risk from parties who don’t want to bear it to those that do, creating added costs that ultimately are passed back to producers in the form of lower prices and to consumers as higher prices.”

All of this brings to mind another Latin phrase that’s worth keeping in mind the next time someone tries to sell you a story about the financialization of commodities markets:
Caveat emptor.

ET Phone Home

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ET Phone Home…There have been many jokes, quips and witticisms about the unfortunately named extraterritoriality (ET) issues related to OTC derivatives rules in the US.

Some have even been funny.

But not everyone is smiling about ET, as this story by Dow Jones/The Wall Street Journal points out:

“European Union and U.K. regulators urged the U.S. to delay new rules for swaps contracts and reconsider how they apply to foreign banks and transactions.  The complaints add to a chorus of concerns, including from Japanese, French and Swiss regulators, that the U.S. is overstepping its jurisdiction.”

What, exactly, is the beef?

According to a letter from the European Commission that’s quoted in the article, the US rules could “lead to duplication of laws and to potentially irreconcilable conflicts of laws for market operators.”

This is a theme we have sounded before.  It’s also one that policymakers from Asia are voicing.  Earlier this week, five regulators from three Asia-Pacific jurisdictions (Hong Kong, Singapore and Australia) jointly signed a letter to the CFTC voicing their concerns.  As their letter states:

“…we are concerned that some of the proposed requirements as they currently stand may have significant effects on financial markets and institutions outside of the US. We believe a failure to address these concerns could have unintended consequences, including increasing market fragmentation and, potentially, systemic risk in these markets, as well as unduly increasing the compliance burden on industry and regulators.”

Is there a solution in sight?

Perhaps.  As Hong Kong’s Secretary for Finance Services and The Treasury separately wrote to US policymakers:

“…we call for greater coordination internationally on implementation of OTC regulations, particularly those with cross-border implications.  We hope the CFTC, SEC and the US Treasury will defer the application of the US rules and regulations over non-US persons and work with the international community on a coordinated framework on regulatory cooperation in cross-border OTC transactions.  We also hope the US authorities would provide greater clarity to the Proposed Guidance and to recognize the OTC derivatives regulatory regimes of overseas jurisdictions on the basis of international standard.”

The lines are open.  Regulators are standing by.

Not So Fast, Let’s Stop and Think

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Today’s New York Times contains an interesting story — “Strong and Fast Markets, But No Time to Think” — that reflects on the trading glitches that roiled equities markets on Wednesday.

The article discusses the evolution in securities trading over the past quarter century. It states that this change has largely been positive, but also points out potential pitfalls.

Chief among them: “…the improved markets also are more prone to disaster.” Why? Partly because “Market makers have been largely replaced by high-frequency traders who use computers that can react to orders in nanoseconds.”

As evidenced by yesterday’s problems, or those related to the “flash crash” in May 2010, no trading system is perfect.

There is an interesting parallel here to the OTC derivatives markets. Current policy proposals might significantly change their structure and the role that market makers play in them. These proposals could transform OTC derivatives from an institutional market with low trading volumes and large notional amounts per trade to a quasi-retail market with vastly higher trading volumes and small notional amounts per trade.

We’re not sure what purpose this would serve. Given the price competition and the extremely tight spreads in the most liquid part of the OTC derivatives markets, the impact on trading costs would appear to be minimal.

It is true that smaller end-users might benefit from lower costs, but any benefit here is likely to be more than offset by the higher costs that larger end-users might incur.

Simply stated, there is very little evidence to support the idea that the proposed changes in the structure of OTC derivatives trading would benefit market participants.

As a result, we do not think these market structure changes were the intent of the G-20 Communique issued in Pittsburgh in 2009 that formed the basis of the legislative proposals that have since advanced in key jurisdictions.

To the contrary, we believe that the overriding goal of post-crisis public policy initiatives is to build a stronger financial system and reduce systemic risk.

Efforts to increase central clearing of trades and to improve regulatory transparency do just that, which is why we and market participants are on board with and helping to drive progress in these areas.

Efforts to change how one market works should clearly be backed up by substantial evidence that those changes will bring improvement. For OTC derivatives, that evidence has been a slow train coming.

No Evidence? No Problem

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“To the market’s credit, there is no evidence that the process has become corrupted by big banks.”

That’s what an article in The New York Times Dealbook says about how credit events are determined in the CDS market.

The comment, unfortunately, is buried deep within the article. It’s easy to miss.

Most of the 800-word piece focuses on how the credit event process has the potential to be flawed. Its basic premise is that the ISDA Determinations Committees (DC) and credit event process appear to operate in a cartel-like fashion.

We stress “potential” and “appear to” for two reasons. First, the article doesn’t actually allege any wrongdoing. As noted above, it acknowledges that there is no evidence to this effect. Rather, the article merely posits that because of the way it operates, there is the possibility that problems might occur.

We’re not sure exactly how the DC process is or can be cartel-like. There are effective mechanisms built into it to ensure it isn’t and can’t be. Most notably, each DC is composed of 10 sell-side and 5 buy-side firms, and an 80% supermajority vote of the 15 members is required to make a credit event determination. Neither the sell-side nor the buy-side alone can force a decision its way; a broad market consensus is necessary.

What other flaws does the article cite?

One has to do with the claims that the DC “operates as a quasi-Star Chamber.” It would be great if we could cast Michael Douglas or Hal Holbrook (the stars of the 1983 movie of that name) in the lead DC roles. But we’re not sure the DC process would qualify as a theme for a remake of the movie. Virtually every part of the process is public: the rules governing the DC; the composition of the DCs; the determination requests made by market participants; the aggregate DC votes; the individual votes of DC members; the auction process and prices; adjustment amounts paid by firms as part of the auctions, and so on.

Another potential problem cited by the article isn’t a problem at all: it’s a source of strength. It has to do with the fact that DCs can be asked to consider and vote on a credit event multiple times as the facts of a situation change.

For example, in the recent situation involving Greece, the ISDA EMEA DC was asked to determine whether a credit event had occurred prior to the execution of the bond exchange. It determined at that time that it had not. Shortly thereafter, the deal was officially executed and the DC was again queried. It then ruled that a credit event had occurred.

This is hardly an example of “details shifting.” It is, rather, a prime example about how specific facts about specific situations involving specific Reference Entities can and do change. Prior to the use of the collective actions clauses (CACs) by Greece, there was no credit event. Following their use, there was.

In other words, facts matter. That’s why it is hard to say that one DC decision is precedent-setting for another.

The article opines that the DCs make decisions without having to publish their reasoning. It fails to note that most decisions are unanimous or close to it, obviating the need for explanations given that the consensus is so widespread. It does, though, note that ISDA and the DCs are currently discussing enhanced disclosures.

The “biggest concern” cited by the article is about potential conflicts of interest. These concerns stem from the fact that DC member firms may have an economic interest in the cases they are asked to rule on.

Two important points need to be made here. The first is that the DC rules incorporate the idea that market expertise – as evidenced by trading volumes – is a good thing to have on the DCs. So it’s no surprise that the DCs will be asked to make determinations on Reference Entities in which they have exposures. The second point is that regulatory disclosures and regulatory transparency provide an important check on any potential conflicts. Regulators have the ability to see a DC member’s exposures and benchmark it against its DC voting. This ability is enhanced under Dodd-Frank, which requires firms to report their OTC derivatives trades to trade repositories. This important check on the integrity of the process is cavalierly dismissed in the article.

At the end of the day, the article says that although there’s no evidence of wrong-doing, “trusting it to remain that way doesn’t seem like a good plan.”

The truth is, the DC process has always been built on the concept of “trust, but verify.” It was built with structural safeguards – checks and balances — to protect its integrity. Those safeguards are working. That’s why “there’s no evidence” of any problems with the process.

That, at least, is something we can all agree on.

Tropical Storm

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Sometimes a story comes along that is so emphatically off-base that it makes you just shake your head and wonder. And sometimes it makes you write a riposte.

A recent opinion piece in the American Banker is a prime example. The main thrust of the article is that the credit default swaps (CDS) market is troubled because it does not function like the equity or options market ‒ you can’t get a CDS quote “on a website like Yahoo or Google.”

Really?

It’s hard to believe this is a serious point of discussion. Of course these markets function differently. From June 7 to June 13, 2012, between 7 and 8 million trades on NASDAQ-listed issues were executed each day. On the NYSE Euronext, about 1.6 million trades in European equities have been executed on average per day over the course of 2012.

In the CDS market, by contrast, about 6,400 contracts are executed each day. Globally. On all reference entities. It would take 1,172 trading days for CDS trading volumes to equal one day’s worth of trading volume for NASDAQ-listed issues. It would take 250 trading days for CDS trading to equal one day’s worth of European equity trading on the NYSE Euronext.

Anyone who knows anything about the CDS market realizes that CDS volume is relatively small, and that trading in most reference entities is not very liquid. A brief look at the DTCC data, for example, reveals that in a recent week (of May 15), the number of reference entities that traded more than 20 CDS contracts per day was 27 out of more than 800. In other words, on the order of 97% of CDS reference entities traded less than 20 contracts per day during that week.

Despite this public data, the article posits that:

“That leads us to perhaps the most saddening question of those posed above: Has there been tacit cooperation among market participants and data vendors to preserve the status quo in the CDS mud pit?

Yes. Perhaps the most egregious form of cooperation is the effort to preserve the impression that there is active trading in a large number of reference names when in fact there is not. I know this having reviewed trading volume reported by the DTCC for all CDS reference names, including U.S. banks, sovereign issuers, and regional and local governments.”

“Preserve the impression?” This is ludicrous. Market participants have been telling anyone who will listen about the dynamics of CDS trading volume.

What could possibly account for this gap in understanding? Particularly given that it comes from a well-respected firm (that is lucky enough to be based in Hawaii)?

Could it be that the signals of CDS trading are sometimes misinterpreted? Or that they conflict with the firm’s own default probability solutions? Witness this:

“Breathless reporters or rating agencies claim ‘Dell’s CDS widen 42%’ when, in fact, there were only 9.6 trades of any kind per day and 1.75 non-dealer trades in Dell during the week ended May 25, according to the DTCC.

Reporters need a story, and the CDS mud pit provides material. Rating agencies need a product that is not a rating, and the CDS mud pit provides one.”

We agree that the trading volume of the CDS market needs to be better understood. And we agree that CDS price signals need to be viewed with the proper perspective. CDS do not aim to predict the probability of default, but they do accurately depict the cost of hedging against default. That is their intended purpose…and it is widely known. Even in Honolulu.

Any Given Sunday….

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Another Sunday, another New York Times column on “you guessed it – derivatives.” This one purports to show how derivatives are costing mass transit riders higher fares and lower services. The story goes like this:

“Bankers have embedded interest-rate swaps in many long-term municipal bonds. Back when, they persuaded states and others to issue bonds and simultaneously enter into swaps. In these arrangements, the banks agreed to make variable-rate payments to the issuers – and the issuers, in turn, agreed to make fixed-rate payments to bond holders.”

At which point we need to stop to point out that the example is actually wrong.  We think what the column meant to say was that “the issuers, in turn, agreed to make fixed-rate payments to the bank.” This would be a classic example of an issuer doing a floating rate bond issuance and then swapping into a fixed rate to lock in its exposure. But we digress:

“These swaps were supposed to save the public some money. And, for a while, they did.”

Oh, maybe this won’t turn out so badly?  But then:

“Then the financial crisis hit – and rates went south and stayed there. Now issuers are paying bond holders above-market rates as high as 6 percent. In return, they are collecting a pittance from banks – typically 0.5 percent to 1 percent.”

To recap: the swaps saved issuers money. They effectively lowered the issuers’ interest payments. This remains true today. But now apparently those savings are not enough. Given the level of interest rates today, the column posits that muni issuers could be saving even more.

Well, if that’s the case, why don’t the states and municipalities refinance their debt and issue new bonds with lower interest rates? The problem, according to the column, is that:

“Well, if you think it’s costly to refinance a home mortgage, try refinancing a derivatives-laced muni.  The price, in the form of a termination fee, can be enormous.”

Banks do charge fees for terminating swaps, based on the market value (or replacement cost) of those transactions. Lower rates could and probably did increase the value of those contracts.

But how is this different from what issuers would face if they had just issued fixed-rate debt in the first place (with no swap)? They would have garnered none of the interest expense savings. And they would have to compensate bondholders in the form of a premium if they now wished to refinance higher–rate debt with lower-rate debt. (That’s why there’s generally a premium paid by issuers who issue callable debt.)

The article then goes on to say:

“Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers.”

It’s not clear what exactly is meant by “deals like these,” but here are a few facts. All of the top companies – and thousands of large, mid-sized and smaller firms – in the US and around the world use interest rate swaps. This suggests that corporations frequently seek to lock in their financing costs.

So now we get to the crux of the column:

 “…the banks are taking advantage of our generosity by gouging us on these toxic deals.”

What, exactly, is toxic about helping municipalities manage their interest rate risk and save money?

A Gathering in Boston

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A flurry of stories over the past week have reported (including this one in the FT) on an interesting meeting recently held in Boston that was attended by leading buy-side and sell-side market participants. The meeting apparently focused on liquidity and electronic trading in the bond markets.

“But, oddly, participants at last month’s meeting in Boston were not especially gung-ho about electronic trading. Some of the largest asset managers do not believe that transparency is automatically their friend. If they want to shift a big block of bonds, a skilful dealer might be able to do it without moving the market. This is more difficult if you’re sending an order electronically for the world to see.

Unlike equities, debt instruments are not homogenous. There is not always a ready market with buyers and sellers. Banks, as responsible (and often reluctant) market makers will take an asset and hold it for some time.”

Now, as noted, the meeting was about bonds, and not OTC derivatives, and most of it does not concern us. But the parallels between some of the issues faced by both markets are strikingly familiar.

What are those parallels?

The buy-side – asset managers and others – want and need flexibility in executing their transactions. This usually means ensuring they have the right combination of price, speed and anonymity, depending on the particular firm and the particular transaction. The market-making function of banks provides this flexibility. Restrictions that would limit either the ability of firms to receive or the ability of market-makers to provide that flexibility are a real cause for concern for all market participants.

As we have stated, and shown in previous research, the OTC derivatives markets are very price competitive and dealers play an important market-making role in them. Derivatives users have access to prices from a variety of dealers in a variety of ways. Proposed changes to a system that works – and works well – need to do more than preserve the status quo (or why do them in the first place); they need to add incremental value.

What Price Transparency?

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Price transparency in the OTC derivatives markets was one of the most widely discussed – and widely reported – topics at ISDA’s 27th Annual General Meeting last week. Here’s the Financial Times on the issue:

A theme of the ISDA conference, which includes large dealers as well as users of derivatives, is that while central clearing reduces systemic risk, regulators should not impose new rules on how derivatives trade, because it could disrupt those established markets and reduce trading volumes.

“Listed and over-the-counter markets are completely different, and it’s important that lawmakers and regulators keep this in mind,” said Mr O’Connor.

He added that the industry was open to more public reporting, but with restrictions such as not revealing the size of very large trades or delaying trade reporting. “We’re not anti-public reporting,” he said.

Mr Gensler said that public transparency after trades was key to reducing systemic risk, by making it easier for clearing houses to ask traders to post additional margin during the day.

So who’s right?

Enter Craig Pirrong, the “Streetwise Professor.” Professor Pirrong disagrees that pre-trade transparency helps to reduce systemic risk: “CCPs will obtain the prices of deals cleared through them, that they can use to determine marks on a periodic basis. Moreover, they have access to information from member firms that will permit marking deals to market. Pre-trade transparency is particularly irrelevant in this context.”

It’s a view echoed by those in the know. As the FT noted,

Michael Davie, head of LCH.Clearnet’s SwapClear platform, agreed that regulators, clearers and market participants must know what is going on, but public reporting isn’t essential.  “Transparency for transparency’s sake, why is that inherently a good thing? In broadly subscribed retail markets it’s incredibly important, but how many people are doing 10-year Czech krona swaps?”

So to sum up: price transparency is not a systemic risk issue. ISDA supports taking steps that reduce those risks, as evidenced by the progress made in clearing and compression and in building trade repositories. The former reduce counterparty risk and the latter increase regulatory transparency.

When it comes to market structure changes, however, we believe the benefits of those changes should outweigh their costs. We don’t think the impact of the rules relating to mandatory trade execution in the US meet that benchmark. The evidence indicates that prices in major segments of the OTC derivatives markets are very competitive and are accessible in many ways (via dealer quotes and screens). These markets are already liquid, competitive and transparent — qualities that are absolutely necessary for markets to function efficiently and effectively.

Speculating on Position Limits

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Amidst the clamor over high gas prices in the US, the editorial pages of The Wall Street Journal and The New York Times both weighed in today on the issue of those prices and whether they are being influenced by speculation.

The Journal’s editorial commented on a briefing held by the Administration in Washington on Tuesday and stated:

“Nowhere in his remarks did the President claim that speculation is doing any harm. He did not cite any negative impact on the oil market. He did not say that speculators are manipulating oil prices, nor did he describe in even the vaguest terms the individuals or institutions that might be involved. He didn’t cite any research. Mr. Obama didn’t even, well, speculate about whether oil prices would be higher or lower if not for unnamed actors who may or may not be affecting the markets.”

The Times, not surprisingly, had a different take. It stated that: “Research…indicate[s] that …excessive speculation, mainly by Wall Street index-fund traders, is needlessly driving up prices…”

What is “excessive” speculation? And what exactly does the Times have a problem with: your garden-variety speculation or excessive speculation?

No matter. The Times editorial goes on to say:

 “…it is important that the administration’s working group on oil and gas price fraud — formed a year ago by Attorney General Eric Holder Jr. — finally weighs in on the question of how, and how much, manipulators and speculators are pushing up prices. The group’s silence raises questions about how serious the White House really is about addressing this issue.”

We all agree that illegal market manipulation is wrong and needs to be policed and prevented. But could it be that the reason for the delay is that there is insufficient evidence to support the idea that speculation is distorting commodity markets?

The editorials go on to discuss the lawsuit that ISDA (along with SIFMA) filed against the CFTC’s position limits rule. (The lawsuit is currently pending in the US District Court for the District of Columbia.) These rules are intended to curb speculation.

The Journal writes that: “…the commission now must defend in court a rule it enacted last fall to curb speculation… the regulator has to find a way to carry the argument without the evidence to support it.”

It notes then-Commissioner Michael Dunn’s statements when the position limits rule was passed:

“ ‘No one has proven that the looming specter of excessive speculation in the futures markets we regulate even exists,’ said then-Commissioner Michael Dunn before the CFTC voted on the new rule last October… Mr. Dunn, a Democrat, provided the swing vote in favor of new limits on the size of trading positions only because he believed the Dodd-Frank law left him no choice.

“But even though he voted for the rule, Mr. Dunn said that ‘position limits may actually lead to higher prices for the commodities we consume on a daily basis.’ Less liquidity makes it more difficult for market participants to hedge their risks, which could raise costs for everyone.”

The Times says this:

“The Dodd-Frank financial reform law directs the Commodity Futures Trading Commission to implement new ‘position limit’ rules, which would curb speculation by limiting the share of the market that traders can control at any given time. Unfortunately, the rules recently proposed by the C.F.T.C. are weak, watered down by disagreements between the Democratic and Republican appointees on the commission. The new rules have already been challenged in court by industry groups that represent banks and derivatives dealers.”

Just to be clear, the basis of our lawsuit was two-fold. First, we believe the position limits rule may be harmful to commodities markets, and to end-users, by reducing liquidity and increasing price volatility. As we stated then: “The evidence is overwhelming that position limits are, at best, unnecessary and may, at worst, negatively impact commodity markets and users. Numerous studies have been conducted by government agencies and others into commodity price volatility and little, if any, support exists for the idea that speculation causes that volatility or that position limits curb speculation.”

We also believe the CFTC’s decision-making process in enacting the rule was procedurally flawed. The rule was adopted without making findings as to the necessity and appropriateness of the position limits, as required by statute. Furthermore, the CFTC failed to conduct any meaningful cost-benefit analysis and lacked a reasoned basis for its rule.

To summarize, there are several questions here: Does speculation distort commodity prices? Will position limits help curb speculation? Did the CFTC properly follow the law in enacting its position limits rule? We believe the answer to each question is no, and that the prevailing evidence supports our position.

Half Empty or Half Full?

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An article in the Financial Times on Monday treated us to another take on the empty creditor hypothesis. Professors Marti Subrahmanyam (NYU) and Pablo Triana (ESADE) write that:

“Bond or loan holders using CDS to gain credit protection qualify as empty creditors: if the borrower gets into trouble, the CDS, if triggered, would cover any losses on the underlying position; if the borrower honours its obligation, the investment is made whole (minus the cost of the CDS protection).”

So what’s the problem? In the opinion of the authors, it’s this:

“Empty creditors are lenders (to a corporation or government) that cease to be concerned about whether the borrower fares well or poorly. Their interests are not aligned with those of other creditors, who prefer that the debtor does well, so that the debt is repaid…

“In a more extreme scenario, the empty creditor may benefit even more by “over-insuring” – purchasing a proportionately larger amount of CDS protection than the debt owned (there is no real limit on the amount of CDS “protection” investors can buy). Obviously, those who did not enter into CDS are not indifferent to bad news as they have a more asymmetric pay-off.”

Our research department wrote a piece that addresses many of these issues a few years ago. We won’t repeat the entire argument, except to highlight a few key points from that piece.

The first relates to whether CDS do indeed lead creditors to prefer bankruptcy over restructuring. It posits that if the ability to hedge using CDS tends to make restructurings less likely than a bankruptcy filing, the correlation between number of defaults and restructurings as a percent of defaults should be lower when CDS are available than when they are not. The paper stated:

“The data show that the correlation between number of defaults in a given year and restructurings relative to defaults in the same year is about 9 percent over the entire sample period. But restricting attention to the period of liquid credit default swap markets, which arguably began in 2003 with the publication of the 2003 ISDA Credit Derivative Definitions and the subsequent initiation of trading in the CDX and iTraxx credit indexes, the correlation jumps to 90 percent. While correlations within small data sets should be interpreted carefully, the correlation statistics presented here would not appear to support the empty creditor hypothesis, according to which the availability of credit default swaps would make restructurings less likely.”

But wait, there’s more:

“Further evidence comes from the list of restructurings that occurred during 2008 and the first half of 2009… During that time, twenty-one firms underwent out-of-court restructurings; credit default swap protection was available on eleven of them (52 percent). And of the restructurings that occurred during that period, four subsequently filed for Chapter 11 bankruptcy; of those four, two had liquid CDS available and two did not. Again, the evidence thus far does not appear to support the empty creditor hypothesis.”

The second point we would make has to do with what the FT article referred to as “over-insuring” and our paper described as “negative economic ownership.”  Again, our paper stated:

“…one may reasonably question the plausibility of the second hypotheses on the basis of how the credit default swaps market treats distressed credit. If an investor were actually to try to build up a negative economic ownership position through overhedging, the strategy would be expensive and unlikely to yield a high return.

…[a]n overhedging strategy is likely to be profitable only if an unusually prescient hedger were to foresee accurately the failure of an investment grade company while the company’s credit default swaps still traded at a low spread. In such a case, the gain might be regarded as a windfall but would not lead to behavior that might affect the functioning of credit markets. And if the anticipated bankruptcy did not occur, the large hedge position could lead to large losses.

…Further, it is not clear how the investor would have been in a position to influence the likelihood of a bankruptcy, and thereby make a positive return more likely, other than by failing to support a restructuring if one were proposed. And as shown already, the evidence regarding restructurings does not support the contention that credit derivatives have had a negative effect on restructurings.”

A final thought: it’s interesting to note that a recent paper by Professor Subrahmanyam (“Does the Tail Wag the Dog?  The Effect of Credit Default Swaps on Credit Risk”) also addresses the empty creditor issue in considerably more detail. The paper is the first empirical work to “formally address the empty creditor concern.”

There is nothing in that paper to change our view that there are many factors influencing the likelihood of an out-of-court restructuring even before considering the effect of hedging using credit default swaps. And beyond the evidence we have provided – which thus far does not appear to support the empty creditor hypothesis – the new evidence they offer is interesting but not conclusive, as there are so many other factors in play. There’s still plenty of doubt regarding whether the empty creditor hypothesis is valid or its impact is negative.