Guilty by Association? Regulating Credit Default Swaps

A wide range of U.S. policymakers initiated a series of actions in 2008 and 2009 to bring greater regulation and oversight to credit default swaps (CDSs) and other over-the-counter derivatives. The policymakers’ 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 certain CDSs enabled mortgage-related security risk to become 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 CDSs guilty by association. Although structured debt securities and CDSs share some similarities and were often utilized together in synthetic securitizations, the financial instruments are highly distinct and underwriters of such securities make 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 CDSs referencing mortgage-related securities was more of an effect than a cause of the rapid growth in mortgage-related securitization.Exemptions by the Securities and Exchange Commission to facilitate the central clearing and exchange trading of CDSs seem desirable, although a significant portion of CDS transactions are unlikely to be improved by utilizing such venues. However, mandatory central clearing is likely unnecessary to reduce CDS counterparty risk and may, in fact, increase counterparty risk to the extent CDS clearinghouses unduly concentrate risk or undermine bilateral risk management. Counterparty risk management in the CDS market has generally been prudent, and systemically troubling CDS transactions arose only from a small portion of the market where financial guarantors sold CDS protection to banks on their mortgage-related debt securities. The role of CDSs in facilitating price discovery also suggests that prohibiting uncovered (naked) CDSs to prevent speculation will decrease transparency in the credit markets. The systemically troublesome CDSs sold by AIG and certain bond insurers were purchased by banks on their mortgage-related securities and not for speculation. Ongoing reforms being undertaken by CDS 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 CDSs are sold by insurance companies, purchased by banking institutions, or likewise utilized by such institutions’ unregulated subsidiaries. However, increasing regulation of all CDS transactions or all users of CDSs does not seem warranted.