March 27, 2009

Guilty by Association? Regulating Credit Default Swaps

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Forthcoming from Entrepreneurial Business Law Journal.

Click here to download this article from SSRN.

In response to a need for greater regulation and oversight of credit default swaps (CDS), recently the Securities and Exchange Commission (SEC), both Houses of Congress, the Treasury Department, and state insurance regulators initiated a series of actions to bring greater regulation and oversight to CDS and other over-the-counter derivatives. The policy makers’ stated motivations echoed widely expressed criticisms of the regulation, characteristics, and practices of the CDS market, and focused on the risks of the instruments and the lack of public transparency over their utilization and execution. Certainly, the misuse of CDS enabled mortgage-backed security risk to be overconcentrated in some financial institutions.

Yet as the analysis in this article suggests, failing to distinguish between CDS derivatives and the actual mortgage-related debt securities, entities, and practices at the root of the financial crisis may hold CDS guilty by association. Although the financial instruments share some superficial similarities, structured debt securities are very different from CDS and underwriters of such securities make financial decisions under a very different legal and economic framework than those made by CDS dealers. Unmanageable losses from CDS exposures were largely symptomatic of underlying deficiencies in mortgage-related structured finance and do not primarily reflect fundamental weaknesses in the risk management and infrastructure of the CDS market. In addition, the development of CDS referencing mortgage-related securities was more of an effect than a cause of the rapid growth in mortgage-related securitization.

The SEC’s exemptions to facilitate the central clearing and exchange trading of CDS seem desirable, although a significant portion of CDS transactions are unlikely to be improved by utilizing such venues. However, mandating central clearing is likely unnecessary to reduce CDS counterparty risk and may, in fact, increase counterparty risk to the extent a CDS clearinghouse unduly concentrates risk or undermines bilateral risk management. Counterparty risk management in the CDS market has generally been prudent, and systemically troubling CDS transactions arose from a small portion of the market involving financial guarantors selling protection to banks on their mortgage-related securities. The role of CDS in facilitating price discovery also suggests that prohibiting naked CDS or all CDS outright will decrease transparency in the credit markets. The systemically troublesome CDS were purchased by banks for hedging, not speculation. Ongoing reforms being undertaken by market participants under the supervision of the Federal Reserve Bank of New York to achieve greater transparency and stability call into question the extent to which additional regulation is necessary.

Policymakers should act to prevent the concentration of CDS risk in regulated institutions, particularly when CDS are sold by insurance companies, purchased by banking institutions, or likewise utilized by such institutions’ unregulated subsidiaries. Reform of all CDS transactions at the instrument level does not seem warranted, however. Over-the-counter derivatives markets are in important ways superior to securitization in effecting risk transfer and thereby provide insights as to the most efficient and stable market microstructure for such purposes and the direction towards which financial modernization should take place.