Credit Default Swaps

Until reading James Rickards' FT article (need to be a registered FT user to view) about the financial crises in Greece I had a feeling there is something fundamentally wrong with CDS trade, but I didn't understand exactly what.

Other columnists say that derivative trading increased risk because: 1. they gave institutes the false sense of security in risk handling - relaying pseudo science mathematical models, as if they were the absolute truth. 2. They increased interconnection between financial institutes strengthening the domino effect 3. They made the investments more complex, harder to understand and thus less transparent.

While all the above-mentioned reasons are true Rickards introduces a simpler flaw with CDS. A regular insurance has a insurable interest. An insurance company giving a person life insurance has an interest in keeping the person alive since that way they will not have to pay the insurance. CDS traders, on the other hand, have an interest to exacerbate any crises since they are not liable for the insurance. As mediator between the two sides of the swap, they earn their income on margins on transactions and the more transactions (like in a volatile situation) the better.

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