On the one hand, I'm hopeful that the emergence of a large standardized CDS market will allow public banks to actually offload default risk to shadow banks, hedge funds, and private equity. The added liquidity and lower bid-ask spreads of a frequently-traded market for standardized risk products could conceivably lower the cost of risk transfers, and allow banks to float through periods of depressed assets and higher defaults without suffering as much damage to their ability to make new loans. This "innovation" would be aimed at the root causes of the Great Depression, S&L Crisis, and GFC.
On the other hand, I remember the key lessons of the GFC. Every loan is different, quality is more subjective than science, and packaging them into a bundle of thousands of similar loans or selling them in tranches does not magically improve the aggregate quality or cause some newbie house flipper inspired by YouTube influencers to be able to make their payments. What happens when the next credit crisis wipes out this market, or the hedge fund / shadow bank / PE companies that the market depends on? It could have the same chilling effect on public banks' ability to lend, right? Plus there is still the effect on the macroeconomy by losing those private sources of capital. Finally, who is to say the counterparties can cover their obligations? Over-extended banks could still be left holding the bag.
60 years ago, the market for stock options was a series of Wall Street literal-shops selling bespoke contracts for guesswork prices to investors who generally had to hold them to maturity. The industry had more in common with pawn shops than today's CBOE, with its standardized contracts, electronic settlement, massive liquidity, and strict counterparty standards. When I think about what it would take to sell CDS to private investors against bank loans, it is hard for me to imagine something like the CBOE because the underlying assets are not standardized or standardizable like shares of stock or indices. I can imagine an auction system where individual loan documentation is uploaded, reviewed by analysts on the other side, and bid on. I could even imagine such auction systems opening to accredited individual investors for the smallest loans. It might be a good application for AI to review documentation on thousands of loans.
Another issue here is that the shadow banks/HFs/PE acting as market makers would have to earn a solid double-digit rate of return most years, even after covering the cost of their army of analysts or AI. The public banks considering making such payments would have to consider earning that rate of return themselves by simply not getting so leveraged that they must hedge. Thus, this marketplace would be (a) a place to unload the risk of loans that the banks know are junk, or (b) a place for banks in trouble to bail themselves out, or be bailed out by leveraged buyout investors. Both are factors that would push UP prices for CDS in an online auction. I suspect the terms would not be attractive on a regular basis to healthy banks making solid loans. Such banks won't even utilize the Fed's discount window, much less visit what is essentially a pawn shop for risk.
Still, Basel 3 is looming at a time when bank balance sheets still have lots of underwater assets not marked to market, housing affordability of metrics are at bubble levels, unemployment can only go up from ~4%, and defaults are rising. If there was ever a time to start a risk marketplace, it is probably now, because lots of banks are looking for a way out.
