The Greek Default Happened — and All Is Well • Eyes in the Sky

How Credit-Default Swaps Worked, and Can Still Improve

As it wrestled with Greece’s debt crisis for the past two years, the European Central Bank took pains to avoid triggering credit-default swaps written on Greek bonds. But on March 9, Greece forced payouts on swaps contracts when it required all private bondholders to forgive more than €100 billion ($130 million) of debt as part of the biggest sovereign-debt restructuring in history. The International Swaps & Derivatives Association, a trade group of large financial institutions, calls Greece’s debt deal a “credit event.” The rest of the world calls it what it is: a default.

Still, no panic has ensued. No contagion has swept over U.S. banks. Yields on strapped sovereigns, including Spain and Italy, ticked up only slightly. The financial markets are treating the CDS trigger as a nonevent.

All of this is a healthy sign that credit-default swaps remain effective instruments to transfer and hedge risk. Banks and other financial institutions rely on them to protect against losses. Others use them as a way to bet on a government’s or a company’s ability to repay debt. Hedge funds especially like credit-default swaps because they offer a low-cost means of taking on credit exposure.

Whether you think any of that is a productive use of capital, credit-default swaps have become so ingrained in the financial markets, with $32 trillion in contracts outstanding, that any hiccup in their use could be disastrous. One reason for the markets’ recent insouciance is that the gross amount of outstanding swaps on Greek debt is about $70 billion, of which only about $3.2 billion remains after buyers and sellers net out their positions. But the bigger reason Greek officials felt they could pull the trigger is that the financial markets have come a long way since the 2008 collapse of Lehman Brothers Holdings. Since then, large banks and investment funds, through the ISDA, have created legally binding procedures, more clearly defined what constitutes a credit event, and written rules for settling contracts after payouts are triggered. Fifty-eight credit events have gone off largely without a hitch.

Still, market players and regulators don’t always know who owes what to whom or whether CDS sellers can make good on their protection promises. Rules to be written as part of the Dodd-Frank financial reform law, which some large banks continue to lobby against, will help. Clearinghouses, for example, which act as the buyer to every seller and seller to every buyer, can reduce the risk of failed transactions and give regulators a window on market positions and prices.

For that reason, regulators should interpret the law broadly and require as many CDS trades as possible to be centrally cleared. Overseers should also require margin — regular payments to a counterparty as the value of a CDS changes — in as many situations as possible. Regulators should require so-called legal entity identifiers that would enable them to know who is conducting trades. And because none of these rules will work if only U.S. dealers follow them, regulators should work closely with international counterparts to establish global rules of the road.

It’s a Bird, It’s a Plane, It’s Your ... Privacy

Consider the Qube. It’s three feet long, weighs about five pounds, and is equipped with thermal and high-resolution cameras. It can fly all by itself, for 40 minutes at a time, hovering noiselessly at up to 500 feet. And it films all it sees.

The Qube, made by AeroVironment, is known as an unmanned aerial vehicle, and it’s one model in a growing fleet of drones now plying the skies above the U.S. These machines, piloted by humans remotely, have proven invaluable in war zones, and their expanding use domestically holds great promise. Governments or non-governmental organizations could use them to coordinate disaster relief. Police could track fleeing suspects. Urban planners and officials could monitor traffic jams, forest fires, or floods in real time.

Their use also creates daunting privacy concerns. Drones will enable far more stealthy and sophisticated surveillance over a far greater range than police helicopters ever could. Some drones can record communications and peer through windows. Others could soon be equipped with facial-recognition technology.

The market for unmanned aircraft should only grow. Congress recently increased research and development funding for drones by about 16 percent, to $2.02 billion in fiscal 2012, according to Bloomberg Government data. Only 1 percent of the 18,000 or so local law enforcement agencies in the U.S. have access to a manned aircraft; many more will find uses for the far cheaper unmanned variety. A bill signed on Feb. 14 charges the Federal Aviation Administration with speeding up the approval process for new operators and with integrating drones fully into American airspace by Sept. 30, 2015.

So how do we reconcile the many benefits drones can offer with the protection of Americans’ privacy?

Start by requiring police to obtain warrants for any drone use that would violate reasonable privacy, except in legitimate emergencies. Any continuous public monitoring a government agency plans — say, of traffic trouble spots — should be made public online.

If drones collect personally identifiable data, it should be subject to fair information practice principles — which require notice that data is being collected about you, choice about how it is used, access to your own collected data, and protection of its security — unless it’s part of a clearly defined investigation.

Drones are a wonder of technological innovation. Properly regulated, they have the potential to vastly improve our lives. But you don’t have to be a technophobe to fear the consequences of a self-imposed panopticon.

To read Jonathan Alter on Romney and Medicare and Jonathan Weil on why bank stress tests were a sham, go to:


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