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Credit Default Swaps on Trial

CHICAGO – The lawsuit filed by the US Securities and Exchange Commission against Goldman Sachs for securities fraud, charging the bank with misrepresenting the way  a collateralized debt obligations (CDO) had been formed, has revived public disgust at credit default swaps (CDS), the instrument used to bet against these CDOs. Before the 2008 financial crisis, CDSs were an esoteric product, known only to a restricted number of sophisticated investors and specialized academics. Today, they are a household name, synonymous with unruly speculation, boundless greed, and, ultimately, systemic instability.

Indeed, CDSs are blamed as one of the main causes of the financial crisis. The legality of Goldman Sachs’ behavior will be determined by a court of law, but CDSs’ odious reputation is jeopardizing the survival of this instrument in the court of public opinion.

Riding the populist wave, several politicians have proposed a ban on CDSs. The recent Greek crisis has further galvanized the anti-CDS camp. After all, isn’t it the fault of the CDS market’s avaricious speculators that Greece was on the verge of default and that Greek public employees have had to endure deep wage cuts?

In a word, no. Far from being the spawn of the devil, CDSs are a useful financial instrument that can improve not only financial stability, but also the way that companies and countries are run. Banning them will do more harm than good. Any attempt in that direction is detrimental, because it would divert attention from the useful goal of disciplining the CDS market to make it more transparent, stable, and efficient.