When Is a Swap Insurance and When Is It Pure Speculation?
We believe that the first type of swap—let’s call it the covered swap—is insurance. The essence of an insurance contract is that the buyer has to have a material interest in the asset or obligation that is the subject of the contract. That means the buyer owns property or a security and can suffer a loss from damage to, or the loss of value of that property.
With insurance, the buyer only has a claim after actually suffering a loss. With the covered swaps, if the issuer of a bond defaults, then the owner of the bond has suffered a loss and the swap provides some recovery for that loss. The second type of swap contains none of these features.
Because the credit default swap market is not regulated, there is no valid data on the number of swaps outstanding, and how many are naked. Estimates of the market were as high as US$62 trillion. By comparison, there is only about US$6 trillion in corporate debt outstanding, US$7.5 trillion in mortgage-backed debt and US$2.5 trillion in asset-backed debt. That’s a total of about US$16 trillion in private-sector debt.
Bucket Shops and Anti-Bucket Shop Legislation in the US—An Important Piece of History in the CDS Debacle
Some history here would be useful. Betting or speculating on movements in securities or commodities prices without actually owning the referenced security or commodity is nothing new. As early as 1829, “stock jobbing,” an early version of short selling, was outlawed in New York. The Stock Jobbing Act was ultimately repealed in 1858 because it was overly broad and captured legitimate forms of speculation. However, the issue of whether to allow bets on security and commodity prices outside of organized exchanges continued to be an issue.
“Bucket shops” arose in the late 19th Century. Customers “bought” securities or commodities on these unauthorized exchanges, but, in reality, the bucket shop was simply booking the customer’s order without executing on an exchange. In fact, they were simply throwing the trade ticket in the bucket, which is where the name comes from, and tearing it up when an opposite trade came in. The bucket shop would agree to take the other side of the customer’s “bet” on the performance of the security or commodity.
Bucket shops sometimes survived for a time by balancing their books, but were wiped out by extreme bull or bear markets. When their books failed, the bucketeers simply closed up shop and left town, leaving the “investors” holding worthless tickets. The Bank Panic of 1907 is famous for J. P. Morgan, the leading banker of the time, calling all the other bankers to a meeting and keeping them there until they agreed to form a consortium of bankers to create an emergency backstop for the banking system.
At the time there was no Federal Reserve. However, a more lasting result was the passage of New York’s anti-bucket shop law in 1909. The law, General Business Law Section 351, made it a felony to operate or be connected with a bucket shop or “fake exchange.” Because of the specificity and severity of the much-anticipated legislation, virtually all bucket shops shut down before the law came into effect, and little enforcement was necessary. Other states passed similar laws.
Section 351 prohibits the making or offering of a purchase or sale of a security, commodity, debt, property, options, bonds, etc., without intending a bona fide purchase or sale of the security, commodity, debt, property, options, bonds, etc. If you think that sounds exactly like a naked credit default swap, you are right. What this tells us is that back in 1909, 100 years ago, people understood the risks and potential instability that comes from betting on securities prices, and outlawed it.
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