Credit Default Swaps "Instruments of Destruction"

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Speaking in Beijing, China on the world economy, George Soros stated unequivocally that Credit Default Swaps (CDS) should be outlawed. Soros formed his opinion based on the severe financial damage caused to American International Group (AIG) and other US companies.

CDS in effect produce profit when the corporate stock value declines. A huge amount of CDS can overwhelm the marketplace and cause a decline in stock values. CDS holders profit when they exercise the CDS at the quoted purchase price versus the current stock price. Hence, forcing the stock value downward produces a profit on the CDS. This forced downward momentum is the basis for Soros argument that CDS are "instruments of destruction".

However, the purchase of Put Options on individual stocks and stock indices works in the same manner with the exception that they expire within a specified period and if the stock has not declined in value sufficiently then the Put Options expire without value.

Soros is stating that, in his opinion, certain derivatives should be banned altogether because the effect on the stock value can be so dramatic. Apparently, Soros has not used this technique to profit on stocks and one wonders whether outlawing the CDS would in fact be a direct benefit to Soros in his investment strategy.

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