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Credit Default Swaps Have Re-Emerged with Deutsche Bank - Have We Learned Nothing?

Potential for Higher Inflation
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Last month, the German-headquartered Deutsche Bank AG--17th largest bank in the world--brought back a practice that’s been shut down for more than 5 years. The investment bank has resumed its credit default swap (CDS) business, an operation they had ceased in 2014.

This business revival is an interesting turn for Deutsche Bank who, in other areas of their business, has been partaking in a “strategic overhaul”. This overhaul has included selling off many of the bank’s assets and letting employees go throughout its multiple businesses around the world.

If you don’t know or can’t remember, credit default swaps are financial derivatives that allow investors to "swap" or offset their credit risk with another investor. It was designed to shift your risk to another party--moving the credit exposure of an asset from one party to another--in order to mitigate the risk of default.

Deutsche Bank re-entered the CDS market with “investment-grade European companies” as their main focus, according to the bank. They have also signaled their intentions to extend the trading to cover banks, insurers, and instruments carrying high yield.

In 2014, the bank ceased operating in the CDS market due to increased regulations brought on by the financial crisis. These regulations made the cost of trading in these types of markets much more expensive. However, the costs have declined significantly in recent times. With this in mind, Deutsche Bank has also announced that its foray into the market will be limited to trading cleared swaps.

This move did not come as a complete shock. Some financial papers had reported as early as a year ago that the bank was planning on getting back into the CDS market even though they were pulling back significantly from other business segments and operations.

Parts of Deutsche Bank, such as their entire equities trading division and large groups of their interest-rate trading departments, are currently being phased out by the bank upon guidance from their CEO, Christian Sewing. In spite of all this, Sewing has indicated that CDS trading may actually get more investment from the company as other areas wind down.

Some of this investment has come in the form of new hires. The bank has brought in credit default swap heavy-hitters from around the industry. They have pulled big names in this sector away from the likes of Barclays Plc, Citadel Securities, Goldman Sachs, and Societe Generale SA.

This trend toward CDS trading is not something that’s happening in a vacuum at Deutsche Bank though. Credit default swaps are quickly coming back in favor across many European trading desks due to signals that the global economy is slowing down. This slowdown is putting many companies under more financial stress which encourages investors to hedge their holdings and take short positions.

If you think about it, this isn’t unlike what central banks across the globe have been doing since before 2018, culminating in that year’s massive round of gold buying and repatriation efforts. What does this mean for investors? Are the risks worth the hedge? Well, that’s sort of the point--you can see the factors that signal “hazard ahead” but you can’t predict the exact moment of the crisis.

So, should investors hedge? Of course, they should. This doesn’t necessarily mean dumping all of one’s assets. It simply means including safer ones, such as holding an adequate amount of gold and silver in one’s portfolio. Remember the all-weather portfolio we covered last year--equal exposure to stocks, bonds, gold (or silver), and cash assets? That’s one robust model that may serve as a good start.

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