In general, I think that derivatives should be limited to those with an "insurable interest". They are simply gambling otherwise and increase risks to the economic system. In addition in cases like this, where the collapse of a company is going to benefit certain parties (albeit I acknowledge that counterparties obviously suffer) there are incentives for corrupt practices.
That would be fraud.
Really? fraud?
Well blow me down!
You seem a bright chap. Has there ever been a case of fraud in the city?
Of course. However there are consequences for fraud, although I imagine you'll lump banks taking too much risk into the fraud bucket to try and make a point.
Anyway, on your idea - banning derivatives without insurable interest on the grounds you are gambling. Working through the steps
1) Hedge Fund has purchased protection on a CDS, paying premiums and gets a lump sum on default (like insurance). This is disgusting in your view.
2) The counterparty is likely the market making desk of an investment bank. They receive premiums but need to pay out a lump sum on default. This is a riskier trade. They won't have any insurable interest either as they are going about their market making business and will likely be taking bid offer by doing the opposite trade with someone else. (granted there will be some scenarios where they have insurable interest but the quickest way for them to make money is the match buyers and sellers).
3) Okay so let's ban this activity on both sides. Desk closes. Jobs lost. But that's not really the point.
4) Another hedge fund or bank is buying corporate bonds. That’s good right? A good solid investment and honourable activity.
5) But hold on! If I buy a bond what is my risk profile? I get coupons every so often, but if the company goes bust I lose my lump sum investment. This looks an awful lot like (2) where we receive CDS premiums but lose the house when company goes bust.
6) Hmm – this is bad as well. Let’s ban trading in corporate bonds apart from primary issuance as we are just gambling again.
7) However, if we kill the secondary market, we kill the primary market because companies are now issuing an illiquid asset which is far less appealing.
8 ) It is now impossible for Companies to raise money by bond issuance, and investors have also lost access to what can be a good investment vehicle.
9) I’m sure we can now do equity derivatives and get the equity market banned as well.
10) In short, regulate things. Don’t ban things.
Why does the concept of insurable interest exist and is enforced in the insurance market?
I could go through your "list" but it is frankly embarrassing. In short, my only suggestion was that "derivatives" unlinked from the primary instrument were gambling and had no economic value. In addition to that they greatly increased risk in the financial system. If you want to debate that point fair enough but to suggest that I was wanting to ban selling bonds in secondary markets or ban insuring against losses by the holders of those bonds is desperate stuff.
The counterparty of the CDS that paid out to the hedge fund has the same risk profile as a bond holder. Calling for banning stuff you don’t understand isn’t a great look.
What has that got to do with it?
Bonds are limited in value. If CDS are limited to that value the systemic risk is obviously lower than if many multiples of the bonds value are in play (and the value of those contracts used as assets for other derivative liabilities).
And you still haven't answered the first question:
Why does the concept of insurable interest exist and is enforced in the insurance market?
The entire City is a casino and is built on liquidity. If you introduce insurable interest the CDS market is dead. There would not be enough customers. Add to that it is unworkable. Every market participant would need to recalculate their insurance interest status every morning.
There is already regulation to at least partially address your concerns (eg compression requirements/capital charges). Why do you want to kill an entire market?