It was reported ( US Democrats draft plan to curb CDS trade) that some politicians want to limit the trading of Credit Default Swaps (CDS) to investors actually holding bonds (deliverable against the notional covered by the CDS).

Buying protection against default can be seen as 'shorting' the debt of a company, similarly to buying a put option on its shares, selling a forward or even short-selling its stock. Politicians, bank managers and regulators have shown consensus regarding the ban on short-selling. Post-analysis has shown the ban had little impact on stopping the fall of banks' stock prices though. Moreover, a wide ban on short-selling contributes to increased bid/ask spreads and increased volatility, so it hurts all market participants (incl. buyers who need to pay more to acquire some stock). An example of regulatory risk?

Ex-post, the right course of regulatory action is relatively clear: while it can make sense to prevent naked short-selling (i.e. it can make sense to force a short-seller to borrow in advance the stock) and while it can make sense to call for rating agencies to do their assessments seriously (instead of just downgrading companies because the share price heads South, narrowly interpreted as a measure of market confidence), short-selling should not be banned all together, as it contributes to liquidity... and liquidity contributes to the proper working of the market. Limiting short-selling to avoid artificial dilution makes sense (naked short-selling means more shares may be sold than shares exist, de facto creating artificial dilution of the company's capital) but limitation and outright interdiction (ban) are different...

The idea of limiting CDS trading to owners of bonds targets restrictions for debt (credit) markets equivalent to sensible limitations on short-selling, but the idea eventually is equivalent to restricting selling shares to share owners; this is quite more potent that just requesting sellers to borrow the shares (find a shareholder who agrees not to sell the shares until they've been returned by the the borrower)! For consistency, restricting CDS to bond holders should come with restricting puts to share holders. But very quickly, the market will be killed, as hedging a put option requires the provider to short the shares. By selling the put, the provider is de facto selling the service to the share holder of selling and buying the shares intelligently in order for the share holders to get some minimal performance out of their shares. But the provider might not necessarily hold the shares yet (they might become its property at the maturity of the put option, if physically settled). A ban on short-selling bans the provider of puts from offering its service to a share holder willing to legitimately ensure he does not lose too much on its investment (by hiring professionals to get out of the investment when/if appropriate)... Would that seem intelligent to bare professionals from offering clever management of legitimate investments?

To increase transparency and reduce credit risk on credit derivatives, organising a CDS clearing house (central counterparty) is the way forward, as some politicians are working on. Standardising a CDS contract is not trivial, due to the uncertainties on both the spread and the recovery (of the deliverable bonds). It is possible to just switch to cash-settled fixed payments (making the recovery irrelevant) but this does not really solve the issue. This allows buying protection on exact notionals, but this creates an estimation difficulty if it comes to buying protection on a real bond... The ISDA is currently working on the details.

It is to be noted that the fallacious idea of forcing CDS to be traded on such a market has also been floated. The listed market for options should teach us better: specific situations might require specific contracts so it is impossible to list every contract. To prevent specificity is not a good idea in itself (imagine a CDS used to protect against the default on a commercial deal with delivery not matching the listed market. That is a legitimate credit risk, for credit protection makes sense, but is based on physical reality of physical goods... and one would want to force the economy to run around financial markets rather than financial markets providing services for better managing the physical world?). Without imposing puts to be traded on exchanges, most of them are, due to transparency and dramatically reduced counterparty risk. By analogy, it is not necessary to impose CDS to be cleared with a central counterparty. It should be in the interest of most participants to do so anyway. OTC trades would remain possible however; the very existence of a central counterparty would make it clear to every participant that OTC trades are more risky; they would trade OTC only if the advantage of tailoring is worth the additional risk.