by Calculated Risk on 7/23/2009 06:07:00 PM

Note: Credit Default Swap (CDS) is an insurance contract for a credit instrument. A naked CDS is when someone buys insurance for an underlying asset that they do not own (like buying fire insurance on a neighbor's house). A put option on a stock is somewhat similar - and you don't have to own the stock to buy the put, but the exchange sets the liquidity rules for traders. And that is probably what will happen with CDS: My guess is non-exchange naked CDS trading will be banned.

From Bloomberg: ‘Naked’ Default Swaps May Be Banned in House Bill

“The question of banning naked credit-default swaps is on the table,” Frank, a Massachusetts Democrat, said during an interview on Bloomberg Television today. The legislative proposal will be released next week, Frank said.
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“Frank has indicated to me he wants a total ban on naked credit default swaps,” [House Agriculture Committee Chairman Collin] Peterson said in a statement through a spokesman today. “While the Agriculture Committee had concerns about this proposal when we considered it in February, I am inclined to support it because I would rather err on the side of caution when it comes to these instruments.”

Credit-default swaps do “perform a useful function” in the economy, Frank said, and there may be “alternatives to banning naked credit-default swaps” if most derivatives are moved to a regulated exchange.

“If we can get rules where almost every derivative is traded on an exchange, and those that aren’t because they are just too unique” are backed by extra capital, he said, “then that may do it.”
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Geithner said that while comprehensive oversight is needed, a ban would be inappropriate.