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Home > Capital Markets Best Practice > Credit Derivatives—The Origins of the Problem

Capital Markets Best Practice

Credit Derivatives—The Origins of the Problem

by Eric R. Dinallo

Executive Summary

The nature of credit swaps explained:

  • The difference between insurance and speculation in CDSs.

  • “Anti-bucket shop” legislation as a precursor to the CDS debate.

  • The origins of the exemption for CDSs.

  • The role of the New York Insurance Department.

  • Steps to bring CDSs under control.


There is no doubt that credit default swaps (CDSs) have played a major role in the financial problems the world now faces. As the insurance regulator for New York, the New York Insurance Department had a role to play in the development of CDSs. As they developed, there was a question about whether or not they were insurance. As they initially were used by owners of bonds to seek protection or insurance in the case of a default by the issuer of the bonds, this was a reasonable question. In 2000, under a prior administration, the New York Insurance Department was asked to determine if swaps were insurance, and said no. That is a decision the department has since revisited and reversed as incomplete. We are now unambiguously in favor of the regulation of CDSs.

Since 2007, when the author took office, the impact of CDSs has been one of the major issues the department has had to confront. In the first instance, the department tackled the problems of financial guarantee companies, known as bond insurers. CDSs were a major factor in their difficulties. More recently, the department was involved in the rescue of AIG. Again, credit default swaps were the biggest source of that company’s problems.

What Is a Credit Default Swap and How Many Varieties Are There?

A CDS is a contract in which the seller, for a fee, agrees to make a payment to the protection buyer in the event that the referenced security, usually some kind of bond, experiences any number of various “credit events,” such as bankruptcy, default, or reorganization. If something goes wrong with the referenced entity, the protection buyer can put the bond to the protection seller and be made whole. Or a net payment can be made by the seller to the buyer. Originally, credit default swaps were used to transfer, and thus reduce risk, for the owners of bonds. If you owned a bond in company X and were concerned that the company might default, you bought the swap to protect yourself. The swaps could also be used by banks who loaned money to a company. This type of swap is still used for hedging purposes.

Over time, however, swaps came to be used not to reduce risk, but to assume it. Institutions that did not own the obligation bought and sold credit default swaps to place what Wall Street calls a directional bet on a company’s creditworthiness. Swaps bought by speculators are sometimes known as “naked credit default swaps” because the swap purchasers do not own the underlying obligation. The protection becomes more valuable as the company becomes less creditworthy. This is similar to naked shorting of stocks.

I have argued that these naked credit default swaps should not be called swaps, because there is no transfer or swap of risk. Instead, risk is created by the transaction. For example, you have no risk on the outcome of the third race until you place a bet on horse number five to win.

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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Further reading


  • Dinallo, Eric. “We modernized ourselves into this ice age.” Financial Times (March 30, 2009). Online at:


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