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- What is a Credit Default Swap?
- What is Contagion?
- How are they related?
- What does Bitcoin have to do with this?
— Greg Foss – #FREEDOM is not free 🇨🇦 (@FossGregfoss) February 27, 2022
Greg is talking about the CDS prices (not shown here) rising and how this can warn us of the possibility of contagion for countries exposed to Russian securities, as Holger suggests: including sovereign debt, and investment grade (IG) and high yield (HY) debt of companies in France, Italy, and Austria.
And how Bitcoin can be a hedge for protection.
Don’t worry, we decipher all this below…
🧐 What is a CDS?
You may have first heard the term Credit Default Swap back in 2008 or 2009, when the entire housing market imploded. Michael Lewis’ book The Big Short went into great detail about the housing market implosion and how a few savvy investors made a killing investing in what are called CDSs. While he explained a lot of it, I still hear people confused about exactly what CDSs are and how they are used in the financial markets.
So let’s clear it up quickly and simply here.
First, a swap is a contract between two parties (like a legal document) that agrees to swap one risk for another. Simple as that. I’ve traded many swaps in my career, typically for fx, trading the risk of the fluctuations of one currency for another.
In the case of the housing crisis, CDSs were used to swap the risk of a tranche of debt (basically a bunch of homeowners loans all rolled into one bond) defaulting on its collective mortgage payments. Owners of the debt could get insurance on the default of that debt by buying CDS ‘insurance’.
That said, unlike typical insurance, you don’t have to prove ownership of what you are insuring when you buy a CDS. You just buy it from whoever is willing to sell that insurance to you. Like buying insurance on your neighbors’ house. If it floods or burns down, you each get an insurance payout.
You may ask, why would someone sell that?
Simple, really. It is all about probabilities and premiums (payments for the insurance). The seller is just betting that the bonds do not default, and they just collect the insurance premiums for a profit.
All that said…
Because a swap is basically a legal agreement, there is what we call ‘counterparty risk’. Just like a bank has a risk when they extend you a loan (you may stop paying), there is a risk the party opposite you in your swap is either unwilling or unable to pay the agreed swap. The trade, in effect, fails, and you as the CDS owner are left holding the bag, uninsured.
There was a lot of this when Lehman Brothers went bankrupt and was unable to pay the CDS insurance they sold to investors. And it was such a tangled mess, even in the instances that Lehman and other banks were just the brokers and there was another counterparty, those got ‘lost’ (basically became untraceable with all the intricate trades) within the implosion.
The CDS owners were out of luck and suffered the loss on their bonds that defaulted, plus the insurance premiums they paid for the now-defunct CDS protection.
🦠 What is Contagion?
Contagion is pretty simple and just means that when there is a default on debt from one company or debt issuer (country, etc.) there will be a contagious effect that will be passed on to similar or related companies or countries.
Like dominoes falling or a string being pulled from a sweater, they cause subsequent dominoes to fall or strings to become loose and/or fall out of the sweater.
When Lehman failed, Bear Stearns (who similarly sold a lot of CDSs) also ‘failed’, and many other banks would have—if they had not been bailed out by the US Government (and your tax dollars). They were all interlinked and exposed to the same risks to varying degrees.
And with Greg’s post above, you can see Holger warns that France, Italy, and Austria are particularly exposed to Russian securities, which would lead to contagion from Russia defaulting.
🔗 How are they related?
The key here is that CDS prices are a good indicator of potential or probable defaults on not just the bonds in question, but also of related bonds.
When you start to see the prices of CDSs rise (insurance becoming more expensive), then the bond holders and traders are hedging themselves for what they perceive as an elevated risk of default.
We will often see a whole bunch of related securities’ CDSs begin to creep up in pricing. We are currently seeing this very thing happen with Russian banks, as investors worry about a run on their cash deposits causing a default of one and then a number of related or similar banks.
Bottom line, watching the prices of CDSs will give you an excellent idea of possible or probable problems in companies and countries (bonds and currencies) as an investor.
Incidentally, you can find current Sovereign Debt CDS pricing here:
🔑 What does Bitcoin have to do with this?
You’ve heard Greg, me, and some others talk about how Bitcoin is the ultimate CDS on fiat currency failures.
Because Bitcoin has an immutable (unchangeable) timechain (list or ledger of transactions) showing the ownership of Bitcoin, a form of money that has an absolute finite supply, it becomes a hedge against a currency collapsing.
If a currency enters hyperinflation, then the ownership of Bitcoin will counteract that loss of purchasing power by being worth more of that currency, or being interchangeable with other currencies, or just by being a form of money itself.
Unlike a CDS, though, Bitcoin never expires, and the only fee is the purchase of BTC itself. Also, and most importantly, there is no counterparty risk. Once you own Bitcoin, it is yours, and there is no default risk on the other side of the ‘insurance’ you own.
About as close to perfect insurance as you can get, IMO. And this is why I recommend having at least 1% of your net worth in Bitcoin. That small amount could protect your whole net worth in a catastrophic financial event.
For more on BTC as insurance against this type of ‘tail risk’, I wrote a simple thread that you can read here:
As a risk trader, I’m always concerned about 'Tail Risks'.
And #Bitcoin hedges against the biggest tail risk we’ve ever faced in the history of the modern financial world:
An all out collapse of fiat currencies.
How? Let’s break it down nice and easy here 👇🧵
— James Lavish (@jameslavish) February 15, 2022
That’s it. I hope you feel a little bit smarter knowing about CDSs and contagion and how you can watch CDS pricing to get clues of possible financial problems on the horizon.
As always, feel free to respond to this newsletter with questions or future topics of interest!