I've been catching up to my reading and came across an incredible story in FT which makes a prima facie case for the very strict regulation of credit default swaps. Here's the gist of it:

As the financial crisis virus has swept around the globe in recent months, Kazakhstan’s banking sector has been engulfed in turmoil. This is not just creating a headache for the Kazakh government and Western creditors, but also highlighting issues about the credit derivatives market that extend well beyond those far-flung steppes.

Take the case of Morgan Stanley’s dealings with BTA, Kazakhstan’s largest bank. A few years ago, BTA – like many of its Eastern brethren – was an up-and-coming darling of the capital markets world, with investment bankers furiously competing to float its bonds, provide loans, and much else.

But earlier this year, when funding dried up for Kazakh banks, BTA fell under the control of the government. Initially BTA wanted to keep servicing its loans, and its creditors, such as Morgan Stanley, appeared happy to play along.

But last week Morgan Stanley and another bank suddenly demanded repayment. BTA was unable to comply, and thus tipped into partial default. That sparked fury among some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses.

One clue to the US bank’s motives, though, can be seen on the official website of the International Swaps and Derivatives Association. One page reveals that just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA.

For it transpires that while the US bank has a loan to BTA it also has a big CDS position on BTA, that pays out if – and only if – the Kazakh bank goes into default. Indeed, some of Morgan Stanley’s rivals suspect that notwithstanding its loan, Morgan Stanley is actually net short the Kazakh bank.

As a result speculation is rife that Morgan might have deliberately provoked the default of BTA to profit on its CDS, since a default makes the US bank a net winner, not a loser as logic might suggest.

Morgan Stanley, for its part, refuses to comment on this speculation (although its officials note that the bank does not generally take active “short” positions in its clients.) And I personally have no way of knowing whether Morgan is short or long, since Morgan refuses to disclose details of its CDS holding.

What is crystal clear is that somebody has been placing big bets on whether or not the banking equivalent of Borat will blow up. Right now more than $700m BTA CDS contracts are registered with the Depositary Trust & Clearing Corp in New York. Last year the BTA CDS contract was so liquid that banks and hedge funds were trading it as a proxy for Kazakh governent debt.

Therein lies the crucial reason why the world outside Kazakhstan should note what has happened to BTA. In some respects, the fact that BTA has spawned so much CDS activity has been rather good for Kazakhstan. After all, if banks such as Morgan Stanley had not been able to hedge their positions in recent years, they might never have provided finance on such a scale to BTA - or any other emerging market banks.

Or, to put it another way, if CDS contracts did not exist, Western banks such as Morgan Stanley would now be nursing big losses at BTA, rather than ending up flat (or even making a profit.)

But the rub for regulators and investors is that BTA credit risk has not entirely disappeared: somebody right now is holding the other side of Morgan Stanley’s contracts and unfortunately there is little way for outsiders to know exactly who.

Worse, the presence of those CDS contracts makes it fiendishly hard to work out what the true incentives of any creditors are. In theory, lenders should have an interest in avoiding default. In practice, CDS players do not. The credit world has become a hall of mirrors, where nothing is necessarily as it seems.

At best, this makes it very difficult to tell how corporate defaults will affect banks; at worst, it creates the risk of needless value destruction as creditors tip companies into default. Either way, the key point to grasp is that this is not just a Kazakh tale.

After all, investment banks and hedge funds have written vast volumes of CDS contracts on western names too. And while the corporate default rate has been low in recent years, it is rising fast.

What is playing out at BTA, in other words, is merely a foretaste of what awaits part of the Western corporate scene too. Call it, if you like, the new face of financial globalisation, albeit one that is unlikely to look quite as funny as those Borat jokes, as companies and investors finally wake up to the implications of this deceptive new credit world.

What was the notional value of derivatives worldwide, $600 trillion?