Speculation

Credit derivatives allow banks, for the first time, to sell credit risk short. In a short
sale, a speculator benefits from a decline in the price of an asset. Banks can short
credit risk by purchasing default protection in a swap, paying the total return on a
TRS, or issuing a CLN, in each case without having an underlying exposure to the
reference asset. Any protection payments the bank receives under these derivatives
would not offset a balance sheet exposure, because none exists.
Short positions inherently represent trading transactions. For example, a bank
may pay 25 basis points per year to buy protection on a company to which it has no
exposure. If credit spreads widen, the bank could then sell protection at the new
market level; e.g. 40 basis points. The bank would earn a net trading profit of 15
basis points.
The use of short positions as a credit portfolio strategy raises concerns that banks
may improperly speculate on credit risk. Such speculation could cause banks to lose
the focus and discipline needed to manage traditional credit risk exposures. Credit
policies should specifically address the institution’s willingness to implement short
credit risk positions, and also specify appropriate controls over the activity.