In Defense of Credit Derivatives

You can always tell when the newsflow slows down in the financial world, because invariably some columnist will trot out another brave reëvaluation of credit derivatives. Here's Scott Patterson:

The power of these derivatives -- most of which were launched just in the past few years -- is scrambling the way some investors think about financial markets. Brian Reynolds of M.S. Howells & Co. says he would be more bullish about stocks, except for pesky credit derivatives.
They "add a whole level of complexity" to the market, he says, due to the ability of bearish investors to make bets that credit markets will deteriorate. If they start to turn lower again, that could reignite fears of a credit crunch, hitting stocks.
Credit markets also are dancing to the tune of these derivatives, experts say. Earlier this year, several Dow Jones indexes based on derivatives of high-yield bonds started selling off before an index tracking the cash market for high-yield bonds dropped. In other words, moves in the derivatives foreshadowed the turmoil that gripped global markets...
Investors such as Mr. Reynolds worry that since credit markets are sensitive to swings by these often volatile derivatives, the broader market may become more vulnerable to panic attacks like this summer's.

Let's take these one at a time. Firstly, credit derivatives aren't "launched". Indexes based on credit derivatives are launched, but those indices, even if they're tradeable, reflect underlying trades in the CDS market, which spring up of their own accord as demand for such instruments rises.

Next, blaming "bearish investors" for markets falling is a bit like that old saw about how it's always short-sellers' fault when a stock drops in price. Markets go up and down, and bulls make money in up markets, and bears make money in down markets. Just because it's easier to make a bearish bet does not increase the chances that a market will fall.

And there's a very good reason why credit indices started falling before bond indices: the CDS market is more liquid than the bond market. Many bonds barely trade, which is why it can take a while for bearish sentiment to show up in bond indices. But because the CDS market is more liquid, credit indices can spot that bearishness earlier. This does not mean that bonds are "dancing to the tune" of the CDS market: it just means that you can't trust bond indices during times of market volatility, because the pricing data underlying those indices might be days old.

Finally, what is meant by "these often volatile derivatives"? We've had one period of extreme volatility in the CDS market, which happened to coincide with extreme volatility in a lot of other markets, too. In fact, the CDS market, as it became increasingly important and liquid over the past few years, surprised everybody with a decided lack of volatility.

Markets do sometimes panic. When they panic, liquidity dries up, and it becomes impossible to buy or sell certain assets. At times like that, asset classes which retain some modicum of liquidity are more important than ever. So I'd be inclined to say that the CDS market, far from making the broader market more vulnerable to panic attacks, in fact has served as a sort of escape valve: a market where panicked traders can let off steam, and important pricing information can be obtained.

To be sure, the CDS market is not perfect. For one thing, credit default swaps aren't securities, and they aren't traded on any exchange, so there's a decided lack of transparency in the market. And yes, at the margin, increased liquidity in the CDS market means decreased liquidity in the bond market, which is not a good thing. But when people start blaming the CDS market for something like a plunge in stock-market prices, treat their claims with a lot of skepticism.