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Author Topic: Why you might want to sell Credit Default Swaps  (Read 3418 times)
copumpkin
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March 30, 2012, 04:00:25 PM
 #21

Last I checked, almost all CDS's were not "naked". Some amount of leverage is utilized, but some collateral is required to secure against a default event.

I'm sure in the bitcoin world you can "write" whatever CDS you want, and anybody can take the other side of the bet, but I sure as hell would want to know you can cover at least some kind of amount in the event of a default.

As you might already know, when an event triggers the CDS, the only amount owed is only that amount after whatever can be recovered from the reference entity (defaulter). As in, after all amounts can be recovered (say .40 BTC per BTC owed), the amount you owe (if you sold the policy) would be the remaining .60BTC/BTC. This usually occurs in a bankruptcy court or adminstrative hearing. Last I checked, no such court or arbiter exists in bitcoin, although escrow services may act in that capacity to some degree. For certain, there isn't much case law to rely upon for bitcoin disputes.

Of course, you can design any CDS you want, but that's how I've seen it done in the past. All things considered, I've been interested in this also.

Yeah, I know, but given how most defaults have happened so far in the lending community, recovery is usually unlikely, and it might simplify things to just make binary CDSes. They're less common in the "real world" due to the pervasive presence of a strong legal system, but I'd imagine they'll be the norm around here.

I also think it's important to distinguish between two meanings of naked CDSes:

  • The buyer of the CDS does not own the debt in question, so he is either speculating (betting) on the default or hedging other risks that are assumed to be correlated with the reference entity's default. This is the common definition of a naked CDS, as far as I understand it.
  • The seller of the CDS does not have the coins he is liable for, so at best he is gambling on the bitcoin exchange rate (to move more funds into bitcoin if he needs to pay out) and at worst he is simply incapable of ever paying his full liabilities if shit hits the fan. As I mentioned earlier, in theory if you can assume that the probabilities of your loans defaulting are completely uncorrelated, it might make sense to be liable for more money than you have, but in general that's a very risky path to go down, especially when everything in this community is so risky and most people do not have experience with assessing risk.

I consider the second meaning of naked CDS (not a standard one, as far as I know) to be a lot scarier than the first one, and would suggest actively discouraging people from doing that by requiring proof of funds. I wouldn't go as far as using an escrow for the coins, because that would kill part of the incentive to actually write CDSes in the first place (they mean you can get paid interest, like a loan, for coins you own, but you can also use the coins in the mean time; have your cake and eat it too!), but CDS writers should be able to prove that they are not only in a financial situation to cover their liabilities, but that they are also responsible and won't take undue risks with the money in question. Perhaps a monthly statement (signed, using that bitcoin client feature for proving address ownership?) showing where the coins are would be enough.

Anyway, thanks for your input. You seem to know what you're talking about, so I'd appreciate any other comments you have on these contracts. There are a number of unique features about the bitcoin credit market that make it hard to blindly apply CDS terms from elsewhere to it, but I think that if we can come up with common features that we'd like to see in them, and possibly even standardize on them, we might eventually see a real market for these things.
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copumpkin
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March 30, 2012, 04:06:09 PM
 #22

So I just went and try to ingurgitate the wikipedia page on CDS.

Interesting read, if somewhat indigest.

One of the interesting take-aways is that if you buy a CDS, you
have multiple "interesting" scenarios, some of which include the
seller of CDS actually defaulting in case of a "credit event".

In other words, if you buy one of these, you might very well find
yourself experiencing the following:

    - imsaguy defaults
    - you turn around, claim a "credit event" has occured
    - copumpkin disappears under cover of the night.

It comes down to evaluating the relative trust you have in either of these
two guys and hang actual numbers on that trust ... outlandish fun for all !  Grin

That's certainly an issue to keep in mind. By buying a CDS, you're not actually killing your risk as much as diversifying your exposure. Most people don't like to have a portfolio with only one security in it, because "all your eggs are in one basket". Similarly, if your entire risk exposure is from one borrower, that should make most people uncomfortable. By buying a CDS from someone (e.g., me), you're spreading your risk exposure across multiple people: if you own 1000 coins of debt from imsaguy and buy 500 coins of protection from me, you're now 50/50 exposed to me and imsaguy. Assuming imsaguy and I are uncorrelated (e.g., he isn't my brother or my partner in crime), other things equal, you're safer this way (and are paying me for the reduced risk).

Risk evaluation is a really hairy topic and there are entire departments at most financial institutions dedicated to measuring it and making sure people don't do stupid things. Things like (co)variance and correlation exist as imperfect measures of it, but their degree of imperfection can't really be known until it's too late Smiley Risky business!
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June 09, 2012, 05:06:29 AM
 #23

Mind = blown

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