This morning I wrote in defense of derivatives. This afternoon, here is an article in defense of credit-default swaps. Writing over at Foreign Policy, Oliver Hart, a professor of economics at Harvard University, and Luigi Zingales, a professor of finance at University of Chicago, Booth School of Business, write:

We’ll explain why a market-based system is the best way to achieve this [meaning some sort of financial regulatory rethink], and how credit default swaps — yes, the same financial tools that helped get us into this mess — can play a role.

The two authors do a very good job at explaining how credit-default swaps or CDSs work.

Despite being viewed by many as a “financial weapon of mass destruction,” CDSs are like any tool that can be used wisely or foolishly. In this context, they are potentially some of the best regulatory instruments available. A credit default swap on an [Large Financial Institutions] LFI is an insurance claim that pays off if that institution fails and creditors are not paid in full. Since the CDS is a “bet” on the institution’s strength (or weakness), its price reflects the probability that the LFI debt will not be repaid. Such CDSs, in essence, indicate the risk that a large financial institution will fail.

They also do a very good job are explaining the logic behind their argument that “credit-default swaps have been demonized as one of the main causes of the current crisis. It would be only fitting if they were part of the solution.”

For more, read here.