Credit Default Swaps Unraveled

Some U.S. and Euro regulators want to ban at least some types of credit default swaps (CDS). Professor Bainbridge explains CDSs and the illogic of squelching them. Among others, he quotes Todd Henderson:

[C]redit derivatives are merely a financial tool that can be used by those exposed to credit risk, say a default by the Greek government or General Electric, to share that risk with others. This lowers the costs of borrowing and helps spread risk. In addition, third parties with no exposure to the particular credit risk can bet on whether the Greeks will default. These secondary-market transactions are the same as an individual buying stock in General Electric betting it will rise. Importantly, these bets provide a liquid market for credit risk, which lowers the cost of hedging for those with primary exposure, and provides the market with better information about whether Greece or General Electric is a good credit risk. Those who might lend to the country or company, those conducting other business with it, and those who might face the risk of default in other ways, can use this information to better plan their activities.

I can't improve on Bainbridge's post; read the whole thing.

(via Wolf Howling)