At the quantum level, the laws of classical physics alter in intriguing ways. In financial markets, at the derivative level, the rules of finance also operate differently.

The derivative industry’s indefatigable advocacy of credit default swaps (“CDS”) centers on the fact that contracts related to recent defaults settled and the overall net settlement amounts were small. Closer scrutiny suggests causes for caution.

The CDS contract is triggered by a “credit event”; broadly, default by the reference entity. CDS contracts on Freddie and Fannie were ‘technically’ triggered as a result of the conservatorship necessitating settlement of around $500 billion in CDS contracts with losses totaling $25 to $40 billion. Government actions were specifically designed to allow the firms to continue fully honouring their obligations. Triggering of these contracts poses questions on the effectiveness of CDS contracts in …