CDS Asymmetry not for Soros
January 29, 2009
Interesting views in an article by George Soros in today's FT. Whilst dealing with the current crisis and the difficulty of its remedy in general, Soros spends a little time on short selling and continuing his warnings about CDS contracts and other OTC derivatives.
In contrast with short selling, where upside is limited but downside risk is not (and increases as more losses are incurred), he explains that effectively shorting a stock through buying a CDS contract has the reversed asymmetry of risk. On buying a CDS, the downside risk is limited (to the premium), whilst the upside risk is unlimited (not sure I agree, maybe practically unlimited is better used). Using this asymmetry in risk profile, he joins John Dizard in railing against what he perceives as the instability caused by the CDS market and "toxic" OTC derivatives.
He suggests that shorting is an acceptable market practice (I guess he would, have made a lot of money from shorting) but that some market constraints might be sensible in re-introducing rules such as no naked short-selling and allowing shorting only on an up-tick.
Most controversially rather than just accepting the common view that CDS contracts need to be traded and cleared within regulated markets, he advocates a more stringent process where OTC derivatives would need to go through a very formal and regulated "issuance" process similar to that undertaken when issuing a new stock on an exchange. Given history and the market's economic need for innovation I struggle to see this happening on a large scale, even in light of the crisis - but I guess nothing is to be ruled out in current times.