Alea, who broke
the news that the CFTC’s proposed CDS futures were being tranformed into bankruptcy
futures, has a provocative post up saying that this is actually a
The CFTC was right to restrict the credit event to bankruptcy
Otherwise sellers of protection would been in the same situation that an insurance
company having to pay up in full for a new house if there was a fire in the
attic.Not an attractive proposition.
Main benefit of the CME contract:
given that the recovery rate is fixed ,it will allow for discovery of the
implied hazard rate.This a Good Thing.
Sellers of protection are always in the position of that insurance
company, though – which is why they insist on getting a bond back in return
for paying out. It’s a bit like the insurance company saying that they’ll pay
out in full on the fire in the attic, but only if they get the house in return.
Now I’m unclear on how the new CFTC contract will work, but I do like the idea
that it will help create a very clear hazard rate, which is similar to the default
probability. I know that Jochen Andritzky at the IMF has a complicated formula
for deducing the default probability from the combination of CDS spreads and
bond spreads, but that doesn’t work when the CDS market simply dries up, as
it has done in the case of Ecuador.
My worry is
that bankruptcy futures will make workouts much messier, but Alea, by email,
I don’t think it will complicate workouts because the event "bankruptcy"
itself terminates the contract and if one party has an incentive to game the
event, the other party, the seller of protection, has an incentive to counter
I’m looking forward to learning more about how these contracts work –
and seeing whether they take off. As Alea points
out, it’s been tried before, unsuccessfully.