Welcome   |   Login   |   Sign Up   |

FINANCE/ How the big banks have made millions with the spread

SERGIO BIANCHI comments on the use of Credit Default Swaps by the big banks, and how they avoid regulations and look after their own interests despite the crisis.

(Infophoto) (Infophoto)

We know all about the difference between the BTP (Italian bonds) and the ten-year Bunds, or almost all about it. We know that the spread did not like the Berlusconi government (well beyond the 500 basis points last November), while the indicator has welcomed the Monti Government, at least at the beginning (between 278 and 330 basis points in March), which was also galvanized at the words of Mario Draghi, the President of the European Central Bank, to the point of appreciating beyond even the rumors that preceded (from 450 basis points in late August to 354 on Sept. 7, the day after the announcement of the purchase of Italian sovereign bonds by the ECB).

We know everything, but not what really matters. What really matters is that, in times of particular volatility of the market, the price discovery, the mechanism of price formation (or differential, in our case) may be strongly influenced by the listing of the most popular credit derivatives, the Credit Default Swap (CDS), traded in unregulated markets and thus basically removed from the control of the authorities and the central banks. Looking at the spread and not at what is happening on the CDS market is like looking at the finger instead of the moon at which it is pointing.

Born for hedging purposes, the CDS is a kind of insurance policy that, behind the periodic payment of a premium, guarantees the buyer an agreed amount if the issuer of the security in the contract fails. To illustrate this point, if I held ten million dollars in BOT or BTP and I were to fear the default of the Italian State, I could buy a CDS and ensure the ten million or, what commonly happens, a fraction of the ten million. If the Italian State were to fail, the person who sold me the CDS, typically a big bank, would pay me the insured amount. The greater the likelihood of default of the security, the higher the premium that the buyer is required to pay periodically to the seller.

The problem is that, over time, instead of hedging tools, CDSs have become mostly speculative instruments. This means that the market rules allow the purchase of what are technically called naked CDS, i.e. CDS written on securities that the buyer does not have. In other words, it is as if you were to enter into a fire insurance policy not on your car, but on that of neighbor without his knowledge. It would not be so strange, then, to see you wandering around the car with a can of gasoline, which would probably not be used to fill the tankā€¦