Naked swaps

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A naked swap is one in which participants run no risk of loss. The holder of a naked swap does not own the underlying asset (such as a bond), making the transaction a form of speculation.[1] It is akin to buying fire insurance on your neighbor's house. If their house burns down the owner of the insurance policy gets paid.

Due to the moral hazard associated with these instruments there have been calls for greater regulation. Financier George Soros opined, "CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them."[2]

Conversely, others consider CDS an important tool for hedging by increasing liquidity in the marketplace.[3]


References

  1. Hearings begin on bill to ban naked credit default swaps. Chicago Tribune.
  2. One Way to Stop Bear Raids. The Wall Street Journal.
  3. The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties. The Brookings Institution.