Commenter "cds_till_i_die" asks:
Can you explain to me the conceptual differences(if there are any) between buying CDS protection on a bond you don’t own and naked short selling…I think I get it but some clarification would be useful.
Happy to oblige. There are two big conceptual differences between buying CDS protection and naked shorting, beyond the simple fact that the former is common and legal, while the latter is uncommon and illegal.
Firstly, the fact that naked shorting is even possible in the first place is due only to the way that settlement conventions work. When you sell shares in the stock market, you don’t deliver those shares immediately, but often only after three days. So an unscrupulous trader can enter into a deal to sell shares without even having the shares to sell; he then has three days to either close out the position or find a borrow.
If naked shorting were legal, it would be possible for traders to overwhelm the market with sell orders, and just keep on selling unlimited amounts of stock until all buyers were exhausted and the stock plunged — until, of course, the mother of all short-covering rallies began, with the short-sellers trying to buy back more stock than actually existed. Basically, naked shorting is a very bad idea and no one thinks it should be legal. It’s equal and opposite to something equally illegal: going out and buying stocks even though you have no money, hoping to sell them quickly at a profit before you have to come up with any cash.
In the CDS market, there’s no such shenanigans. There’s no taking advantage of settlement conventions: instead, you’re just agreeing to a swap, where one person will make a regular stream of payments to the other, in return for getting a highly irregular single payment in the future, should a certain reference entity default.
Now selling default protection, like buying a bond, is a way of taking on credit risk. Similarly, buying default protection, like selling a bond, is a way of reducing credit risk. So in that sense, buying CDS protection on a bond you don’t own is a bit like shorting a bond. Not naked-shorting, mind, just regular, common-or-garden shorting, where you borrow the bond from someone who has no intention of selling it, and then you sell it in the market. Once you’ve sold the bond, you can invest the proceeds in something that you think is going to go up; meanwhile, you hope that the price of the bond is going to go down, so that when you buy it back you make a profit on both legs of the transaction.
But in fact buying a CDS is more benign than shorting a bond. When you short, you’re borrowing from someone who might be long, but isn’t actively buying. But then you sell into what might be quite an illiquid market — which can in and of itself drive down the market price of the bond. In the CDS market, by contrast, when you buy protection you’re buying from someone who is actively selling credit protection, and the cash market might not be affected at all.
In that sense, buying default protection isn’t like shorting a bond: instead, it’s much closer to buying a put option on that bond. It’s a zero-sum derivatives transaction, and in the vast majority of such transactions, cash-market prices are unaffected. Just look at the volume of puts and calls being traded on individual stocks every day: that options market very rarely affects the underlying stock market.
Now the corporate-bond market, being more illiquid than the stock market, is easier to move, and a bit of delta-hedging by the sellers of default protection might be all that’s needed to move it. But still, buying default protection is a pretty roundabout way of trying to move a market, and is in fact the choice you would make if you wanted to protect yourself from downside while running as little risk as possible of driving the market down by doing so.
Buying CDS, then, is much closer to buying puts than it is to shorting, and it’s much closer to shorting than it is to naked shorting: it’s at least two steps removed from the kind of manipulative and illegal activity that naked-shorting bans were devised to prevent. It is a fundamentally bearish thing to do, and any bearish market activity has the ability to move markets down. But in the demonology of bears, CDS buyers don’t belong anywhere near naked shorters.