How default swaps become instruments of mass deception

Credit default swaps are a form of insurance against bond defaults. In this story, they feature as instruments of deception rather than “weapons of mass destruction”, the label once applied to all derivatives by Warren Buffett. You can speculate about whether investors were deceived by their own instincts or other factors. This does not change the story, or its takeaways.

The price of Deutsche Bank CDS spiked during the afternoon of Thursday, March 23, and the following morning. Boaz Weinstein, founder of hedge fund Saba and a CDS expert who once worked for Deutsche, highlighted this in a tweet. “[I am] hearing it’s partly due to counterparty hedging,” he wrote, “but the move is really violent.”

Other pundits piled on. They smelled blood. Deutsche has some common features with struggling Credit Suisse, which Swiss officials had jammed together with UBS days before. “Banking doom is back in Europe,” one tweeted. “Markets price 31 per cent default probability for DB subordinated bonds.”

Deutsche shares dropped more than 14 per cent. This generated big gains for short sellers. They had sold ahead about 3 per cent of Deutsche’s shares, according to filings.

The FT’s Lex column, which is no fun at all in a market panic, wrote that Deutsche was not going bust. That weekend, German officialdom did not jam Deutsche together with Commerzbank or anyone else by way of a rescue. Deutsche shares clawed back their losses over the next few days.

Confirmation bias is the human tendency to use new information to justify existing beliefs. Investors were already anxious about Deutsche. It is a famous, underperforming northern European bank, like Credit Suisse, though its period of risk-taking mismanagement was longer ago. Credit Suisse CDS had run up sharply before Swiss authorities stepped in.

But CDS are bad barometers of whether a bank is in trouble. “This is a quirky little market,” says one trading boss. “It is illiquid and trade reporting is patchy.” In the US, new CDS transactions cover corporate bonds worth about $3bn daily at far lower cost than that figure. This compares with transactions worth almost $50bn in the underlying bonds.

In addition, traders say as little as a quarter of CDS involve worried investors insuring against bond defaults. Banks, for example, often buy CDS on their own bonds to keep the risk exposure of their trading books within regulatory limits.

It is straightforward enough to calculate a one in three risk of default from a steep five-year CDS price, as Twitter habitués did. But the sum has two fatal flaws. First, it includes an estimate of the amount debtors might recover if an issuer defaulted. But EU and German financial regulators would step in before Deutsche was in such dire straits. Second, the sum does not compensate for the illiquidity of a market where small deals exert heavy sway on prices.

Derivatives are geared instruments. But if CDS are rising by 25-30 per cent in a few hours and bond prices are only falling 3 cents on the euro in response to the same risk, it suggests the price relationship is a loose one. This was what happened to Deutsche.

Investors, in the guise of Chicken Little, seemed not to notice. An acorn, in the form of a CDS spike, had fallen on their heads. They were convinced the sky was falling.

Regulators suspect that someone — vulpine short sellers, presumably — dropped that acorn deliberately. Andrea Enria, top supervisor of the European Central Bank has called for a market review. It would not be a total surprise if this recommended central clearing and greater trade transparency for CDS. Regulators always want more of both these things.

A more aggressive regulatory response would be to ban anyone from buying bank CDS if they did not have some exposure to the underlying bonds. The EU imposed a curb on purchases of so-called naked CDS on sovereign bonds in 2011 in the wake of the great financial crisis. It could extend the ban to CDS on the bonds of global systemically important banks — the world’s top-tier lenders.

I have a simpler solution: investors should try harder to distinguish between acorns and the sky falling on their heads. The characteristics of the CDS market mean the prices it generates are of anecdotal interest, rather than fundamental importance.

When panicking, stop, breathe, think. It works in physical emergencies. It should work in financial emergencies too.

jonathan.guthrie@ft.com