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Rethinking Global Economic Governance in Light of the Crisisthen hedge its position by buying CDSs. So the net is much less than the gross, but thechain is based on the view that each party can and will make good on its contract. Ifthere is a failure, the rest of the chain is exposed, and fears of counterparty risk can causea drying-up of liquidity. The long chains may create large and obscure concentrationrisks as well as volatility, since uncertainty about any firm echoes through the system.Naked CDSs increase leverage to the default of the reference entity. They can therebysubstantially increase the losses that come from defaults. And the leverage comes at lowcost – nothing equivalent to capital requirements, no reserve requirement of the kindinsurers must satisfy.What are the policy implications? We do find that for Eurozone sovereign debt, theCDS and cash market prices are normally equal to each other in long-run equilibrium,as theory predicts. One interpretation is that the derivative market prices credit riskcorrectly: sovereign CDS contracts written on Eurozone borrowers seem to be ableto provide new up to date information to the sovereign cash market during the period2004–11. In the short run, however, the cash and synthetic markets price credit riskdifferently to various degrees. Second, the Eurozone CDS market seems to move aheadof the corresponding bond market in price adjustment, both before and during the crisis.CDS contracts written on Eurozone borrowers seem to be able to provide new up todate information to the sovereign cash market during the period 2004–11. And CDScontracts clearly do play a useful hedging role. None of this, however, justifies nakedCDSs, which appear to play a destabilising role both in theory and in various episodesof the financial crisis.102