Rajiv Sethi is a clever guy and I have respected his work in the past, but I think that he is materially mistaken about naked CDS. In a recent paper with Yeon-Koo Che he writes:
Those who are most pessimistic about the future prospects of the borrower will be inclined to buy naked protection, while those most optimistic will be willing to sell it.
This is the first, and most important misconception. CDS trading is not about speculating on default: it is about credit spread movements. In other words, people do not buy CDS protection, typically, because they think that the market view of default is too optimistic; nor do they sell it becase they are optimists on the credit. They buy CDS because they think that the credit spread is going to go up: they sell it because they think that it is going to go down.
The next error is to suggest that protection sellers
… have to support their positions with collateral, which they do by diverting funds that would have gone to borrowers in the absence of derivatives.
This too seems to me to be a huge stretch which requires considerable justification. Collateral is usually cash, and it earns OIS. To turn liquidity into a risk position involves an asset reallocation decision which, if made generally across a bank, would dramatically change its risk profile. No, if there were no derivatives, it is highly likely that that money saved from not having to post collateral was invested in FED funds, or in some similar low risk, low return form.
Next we get to something that I think the authors should do much better. They gaily state
For reasons that are already clear from the baseline model, we find that … [some situations] involve more punitive terms for the borrower when naked credit default swaps are present than when they are not.
Given that this is the major conclusion, to say that it follows from the (in detail unspecified) model is, to put it politely, sleight of hand. If we look at the detailed paper, we find a slightly more nuanced exposition:
The availability of such contracts [as naked CDS] can shift the terms of debt contracts against borrowers by inducing optimistic investors to divert their capital away from financing real investment and towards the support of collateralized speculative positions.
In other words, the conclusions rely on the assumption that CDS protection sellers would otherwise take credit risk with their collateral, something that is highly unlikely. Typically CDS protection buyers, especially naked ones, value CDS precisely because of their liquidity and their leverage, neither feature of which is present in the bond market (unless you repo the bond – but that is another story). Thus what appears to be a carefully, academically rigourous critique of naked CDS is nothing more than a farrago of erroneous assumptions and conclusions. Caveat lector.
Update. Bug that Rajiv pointed out fixed above.