Naked CDS, market efficiency and the run on Greece

Rajiv Sethi makes the case that prohibition of naked credit default swaps can be supported on the grounds of Diamond and Dybvig's financial instability model:
"In this case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic. What does this have to do with naked credit default swaps? As John Geanakoplos notes in his paper on The Leverage Cycle, such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation."

Even if we thought that naked CDS speculation is not stabilizing, it is important to realize that self-fulfilling run can happen without any possibility of shorting. If some traditional bond investors are afraid that other traditional bond investors will not roll over their investments in Greek bonds, crisis can happen without any involvement of hedge funds. Without leverage embedded in naked CDS, most probably such crisis will occur later, when Greek debt/GDP ratios and deficits become larger. This just means that adjustments caused by the crisis will happen later, but they will be much more painful. Criticism of naked CDS will not move us closer to the ultimate solution of the financial instability problem. The real answer to the current crisis is better monetary policy, macroprudential regulation of systemwide leverage and a more effective version of European Stability and Growth Pact that should include the eurozone member equivalent of bank deposit insurance. Criticism of naked CDS will not move us closer to the ultimate solution of the financial instability problem.

There is also a strong argument for allowing naked CDS on market efficiency grounds. One of the most important assumptions behind the capital asset pricing model is unlimited shorting. Naked CDS allow market participants to move prices of credit instruments closer to mean-variance efficient frontier and in this process efficient market hypothesis becomes more applicable to bonds. Bond markets inefficiently ignored the Greek violations of European Stability and Growth Pact before the crisis because there was not enough leveraged shorting of Greek bonds. Don't get me started about how bond markets inefficiently allowed Iceland to ruin itself.