Systemic Risk: Regulatory Oversight and Recent Initiatives to Address Risk Posed by Credit Default Swaps
Published: 2009-03-05T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The U.S. financial system is more prone to systemic risk today because (1) the current U.S. financial regulatory system is not designed to adequately oversee today's large and interconnected financial institutions, (2) not all financial activities and institutions fall under the direct purview of financial regulators, and (3) market innovations have led to the creation of new and sometimes complex products that were not envisioned as the current regulatory system developed. Credit default swaps (CDS) are one of the products that have assumed a key role in financial markets. My statement will discuss (1) the extent to which U.S. financial regulators and the UK regulator oversee CDS, (2) risks and challenges that CDS present to the stability of financial markets and institutions and similar concerns that other products may pose, and (3) the recent steps that financial regulators and the industry have taken to address risks pose by CDS and similar efforts that may be warranted for other financial products. GAO reviewed research studies and congressional testimonies. We interviewed financial regulators and a variety of financial market participants. In January 2009, GAO designated the financial regulatory system as a high-risk area in need of congressional attention. Issues involving systemic risk regulation in general and CDS in particular should be considered as part of that effort.
section_title: What GAO Found
paragraphs: The current regulatory structure for CDS does not provide any one regulator with authority over all participants in the CDS market, making it difficult to monitor and manage potential systemic risk. Federal oversight of CDS trading and monitoring of the CDS market are largely conducted through the banking regulators' safety and soundness oversight of supervised banks that act as CDS dealers. The Securities and Exchange Commission and the Commodity Futures Trading Commission lack the authority to regulate CDS broadly as financial products. Regulators have sought to address potential systemic risks arising from CDS activities mainly through collaborative efforts with other supervisors and key market participants. However, the extent to which regulators routinely monitor the CDS activity of unregulated market participants is unclear. The Financial Services Authority in the United Kingdom has authority over most CDS products and can collect information about the CDS market, but it has pursued most of its regulatory efforts in collaboration with U.S. regulators. CDS pose a number of risks to institutions and markets, many of which are not unique. These include counterparty credit, operational, concentration, and jump-to-default risks. Market participants and observers noted that CDS referencing asset-backed securities (ABS) and collateralized debt obligations (CDOs), particularly those related to mortgages, currently pose greater risks to institutions and markets than other types of CDS. Other risks and challenges from CDS relate to the lack of transparency in CDS markets, the potential for manipulation related to the use of CDS as a price discovery mechanism, and the use of CDS for speculative purposes. Regulators and market participants noted that over-the-counter (OTC) derivatives, to varying degrees, may pose some similar risks and a few identified equity derivatives as the OTC derivatives that were most similar to CDS. Financial regulators and market participants have initiated several efforts to mitigate these risks. These efforts target primarily operational and counterparty credit risks and include improving the operational infrastructure of CDS markets, creating a clearinghouse or central counterparty process to clear CDS trades, and establishing a central trade registry for CDS. If effectively implemented and sustained, these initiatives couldbegin to address some of the risks noted. But the effectiveness of these recent initiatives could be limited because participation is voluntary and regulators lack the authority to require all market participants to report their trades to a repository. Moreover, customized and highly structured CDS, which can include CDS with complex reference entities that may present additional risks, generally lack the standardization necessary for centralized clearing. Other ideas to reform CDS markets, such as mandatory clearing or limiting some types of trades, have important limitations that would need to be addressed. Finally, many participants and observers agreed that OTC derivatives other than CDS generally share some of the same risks and could benefit from similar efforts to mitigate their impact.

section_title: Letter
paragraphs: I appreciate the opportunity to participate in the hearing today to broadly  discuss systemic risk and in particular the systemic risk posed by credit  default swaps (CDS) and other over-the-counter (OTC) derivatives. As you  well know, there is no single definition for systemic risk. Traditionally,  systemic risk was viewed as the risk that the failure of one large institution  would cause other institutions to fail. This micro-level definition is one  way to think about systemic risk. Recent events have illustrated a more  macro-level definition: the risk that an event could broadly affect the  financial system rather than just one or a few institutions. In our January  2009 report on the U.S. financial regulatory system, we pointed out that  the current regulatory system was not designed to adequately oversee  today’s large and interconnected financial institutions, whose activities  pose new risks to the institutions themselves and systemic risk to the  broader financial system. We also noted that not all financial activities  and institutions fall under the direct purview of financial regulators and  that market innovations had led to the creation of new and sometimes  complex products whose complexity and substantial role in the financial  system was not envisioned as the current regulatory system developed.  Credit default swaps are one of the products that have assumed a key role  in financial markets. They are being used by financial institutions that are  subject to varying degrees of regulation, and the market for CDS is largely  unregulated in the United States.
My statement today focuses on the results of prior work and our recent  review of CDS and the risks that they and other OTC derivatives pose to  the financial system (initiated at the request of Ranking Member Bachus  and Chairman Kanjorski). Specifically, I will discuss (1) the extent to  which U.S. financial regulators and the UK regulator oversee CDS, (2)  risks and challenges that CDS present to the stability of financial markets  and institutions and similar concerns that other products may pose, and  (3) the recent steps that financial regulators and the industry have taken to  address risks posed by CDS and whether similar efforts may be warranted  for other financial products.
To achieve our objectives, we analyzed publicly available reports,  congressional testimonies, and other documents issued by international  financial organizations, academics, financial regulators, industry groups,  and market participants. We also corresponded with the New York State  Insurance Department, the UK Financial Services Authority (FSA), and  two clearinghouses. We interviewed staff from the Board of Governors of  the Federal Reserve System (FRS), Commodity Futures Trading  Commission (CFTC), Federal Reserve Bank of New York (FRBNY), Office  of the Comptroller of the Currency (OCC), Office of Thrift Supervision  (OTS), President’s Working Group on Financial Markets (PWG), and the  Securities and Exchange Commission (SEC). Finally, we spoke with  representatives of three CDS dealer banks, a credit rating agency, an  industry trade group, five hedge funds, a large provider of derivatives trade  and settlement services, and a large provider of CDS pricing and valuation  services, as well as speaking with two industry observers. We provided a  summary of our findings to the FRS, OCC, OTS, and SEC, and this  statement was based on those summaries and incorporates their  comments as appropriate.
We conducted our work from October 2008 to February 2009 in  accordance with all sections of GAO’s Quality Assurance Framework that  are relevant to our objectives. The framework requires that we plan and  perform the engagement to obtain sufficient and appropriate evidence to  meet our stated objectives and to discuss any limitations in our work. We  believe that the information and data obtained and the analysis conducted  provide a reasonable basis for our findings and conclusions.
subsections: section_title: Background
paragraphs: As originally designed, CDS are bilateral contracts that are sold over the  counter and transfer credit risks from one party to another. The seller,  who is offering credit protection, agrees, in return for a periodic fee, to  compensate the buyer, who is purchasing it, if a specified credit event,  such as default, occurs (see fig. 1). There are three standard types of CDS  contracts, depending on the underlying reference entity.
A single-name CDS is based on a single reference entity such as a bond,  institution, or sovereign entity.
A multi-name CDS references more than one corporate or sovereign entity  and can be divided into those that reference at least 2 but not more that 10  entities and those that reference more than 10 entities.
An index CDS is based on an index that may include 100 or more  corporate entities.
The contract term often ranges from 1 to 10 years, with most standard  CDS contracts having a 5-year duration.
Participants in the CDS market include commercial banks, broker dealers,  hedge funds, asset managers, pension funds, insurance and financial  guaranty firms, and corporations. CDS can provide a number of benefits,  such as giving some market participants another tool to manage credit  risk. They also are a way to replicate an investment in a debt instrument  such as a bond. However, in 2008, as the United States and the world faced  one of the worst financial crises in history, some market observers  identified CDS as one of several financial products they believed had  contributed to the overall tightening in the credit markets following the  bankruptcy of Lehman Brothers and the near-collapse of American  International Group (AIG), which was a major CDS seller. Although  authoritative information about the actual size of the market is generally  not available, some have estimated the amount of outstanding contracts— as measured by the notional amount of the CDS contracts—at over $50  trillion in 2008. However, more recent figures place the notional amount at  around $28 trillion, in part reflecting trade compression efforts. These  market events and the estimated size of the CDS market have raised  concerns about the risks that CDS and similar financial products may pose  to the stability of the financial system. Furthermore, questions have been  raised about the current level and structure of oversight of CDS and their  impact on the financial system. In the last 3 years, CDS market  participants and financial regulators have been taking actions to help  mitigate various risks and challenges related to CDS activities, with a  particular focus on the market’s infrastructure.
section_title: CDS Oversight Highlights the Challenges of an Outdated Regulatory System
paragraphs: In the United States, federal financial oversight of CDS is limited. Banks,  whose activities as CDS dealers account for a large percentage of CDS  trading, are subject to safety and soundness oversight by banking  regulators. Bank regulators therefore have the authority to act on their  concerns about the extent to which a banking organization’s CDS trading  affects the health of the bank. However, oversight of banks acting as  dealers does not directly extend into the CDS product market itself. In  addition, federal financial market regulators—primarily SEC and CFTC— are generally limited or restricted in their ability to oversee CDS broadly  as a product because they lack statutory authority. SEC has antifraud and  antimanipulation authority over CDS, but it may face challenges in  enforcing this authority because of statutory restrictions on its rule- making ability. Federal financial regulators have sought to address  potential systemic threats arising from CDS activities mainly through  collaborative efforts with other supervisors and key market participants.  While U.S. federal financial regulators do not have authority over CDS as a  product, in the United Kingdom, which has a CDS market comparable in  size to the U.S. market, FSA has authority over most CDS products.  However, its regulatory efforts have generally been pursued in  collaboration with U.S. regulators.
subsections: section_title: Federal Regulation of CDS Generally Focuses on the Activities of Dealer Banks
paragraphs: Federal banking regulators can oversee the CDS activity of the financial  institutions they supervise. These regulators’ oversight captures most CDS  activity because banks act as dealers in the majority of transactions. All of  the major CDS dealers are commercial banks or subsidiaries of bank or  financial holding companies that are subject to regulation by U.S. or  foreign holding company regulators. Also, bank regulators have some  authority to review the effect of a bank’s relations with an affiliate on the  health of the bank. However, bank regulators do not regulate the CDS  markets. Moreover, bank regulators generally do not differentiate CDS  from other types of credit derivatives in their supervision of institutions,  because most credit derivatives volume is comprised of CDS. Regulators  focus their oversight on institutions’ derivatives portfolios regardless of  their structure.
Banking regulators’ oversight of CDS activity is largely limited to activity  that is deemed to pose risks to the safety and soundness of the institutions  they regulate. Accordingly, federal banking regulators generally oversee  dealer banks in the U.S. mainly as part of their ongoing examination  programs. However, as we reported in 2008, some regulators continued to  be concerned about the counterparty credit risk created when regulated  financial institutions transacted with entities that were less regulated, such  as hedge funds, because these activities could be a primary channel for  potential systemic risk.
FRS officials explained that when examiners identified an increasing use  of credit derivatives at certain regulated banks, they expanded the scope  of their examinations to include a review of risks arising from the banks’  trading of these products. These exams generally were broad in scope,  although occasionally they focused on CDS, and assessed the products’  financial risk and the way banks monitored and managed that risk.  According to officials, some of the examination findings included  concerns related to management of counterparty credit risk, including  collateral practices, risk management systems, models for risk  identification, and governance issues.
OCC officials explained that, as the prudential regulator of the large dealer  banks, its on-site examiners conducted ongoing risk-focused examinations  of the more complex banking activities, which could include CDS  transactions. OCC targets its risk-focused examinations using risks or  trends that it notices across banks. According to OCC officials, its on-site  examiners monitor derivatives activity daily in the large dealer banks and  look for trends and exceptions in the banks’ information to gauge risk. For  example, they may examine new counterparties that have not gone  through an internal counterparty review process. OCC also conducts a  quarterly analysis of the derivatives market using call report data  submitted by all insured U.S. commercial banks to evaluate risks from  trading activities, including CDS, in the national banking system. However,  this oversight does not provide a clear snapshot of potential  concentrations of risk in participants outside of national banks. Similarly,  FRBNY collects data from OTC derivatives dealers that participate in an  FRBNY-led initiative to improve the operational infrastructure for CDS,  including information on operational metrics such as confirmation  backlogs and transaction volumes but not on CDS exposures.
Under consolidated supervision, some subsidiaries of holding companies  that engage in CDS activities may not receive the same degree of  monitoring as regulated entities receive from their prudential supervisors.  OCC officials explained that, while most CDS activity is conducted in  banking entities because CDS trading is a permissible bank activity, some  derivatives activity is conducted in nonbank subsidiaries of holding  companies. OCC, like other federal bank regulators, has authority to  review how a bank’s relations with an affiliate (specifically, an affiliate  that is not a subsidiary of the bank) affects the health of the bank.  However, OCC supervises the bank, not the affiliate. In such cases, OCC  officials said that they would collaborate with FRS to examine activity in  the other nonbank subsidiaries if they deemed it necessary.
Similarly, even though SEC oversees broker-dealers, the agency does not  regulate the CDS markets they deal in. Until September 2008, SEC  provided oversight of major investment bank conglomerates at the  consolidated level through its Consolidated Supervised Entity (CSE)  program. According to SEC officials, investment banks generally  conducted CDS transactions in subsidiaries not registered as U.S. broker- dealers, and therefore SEC did not have an ongoing on-site examination  program for these entities. Rather, the CSE program monitored  information aggregated at the holding company level that included the  activities of these affiliates, including their CDS transactions. According to  SEC, a significant part of the CSE supervision program was dedicated to  monitoring and assessing market and credit risk exposures arising from  trading and dealing activities. The CSE program conducted targeted exams  related to three specific projects—reviews of liquidity pools, price  verification of commercial real estate, and management of counterparty  exposures—which SEC officials explained could include CDS activities  but did not have CDS as a specific focus.
Similarly, OTS is responsible for overseeing thrift holding companies  through its consolidated supervision program. These entities include AIG,  GE Capital Services, Morgan Stanley, and American Express Company,  which are large global conglomerates with many subsidiaries. OTS does  not conduct ongoing on-site examinations of all unregulated subsidiaries.  OTS officials explained that the agency monitored the holding companies’  enterprisewide risk-management practices to determine how the  companies identified and managed risk and supplemented this monitoring  with limited on-site visits of unregulated subsidiaries as it deemed  necessary. For example, when AIG’s external auditor identified internal  control problems with AIG Financial Products, a nonthrift subsidiary that  was active in the CDS market and ultimately identified as posing a  systemic risk to the financial system because of its role in the market, OTS  examined its operations. However, OTS officials told us that thrifts  generally have engaged in limited CDS activities.
Federal financial regulators generally supplement data from their  supervised entities or other information they collect with data from  sources such as the International Swaps and Derivatives Association, Inc.  (ISDA), the Bank for International Settlements, the British Bankers  Association, and the rating agency Fitch to compare their banks to the  larger universe of market participants. More recently, information has  been available to regulators from the industry’s central trade repository,  the Trade Information Warehouse (TIW).
section_title: CDS Are Not Generally Regulated As a Product, Making Monitoring Their Role in the Market a Challenge
paragraphs: Federal market regulators—SEC and CFTC— do not have authority to  regulate the CDS markets directly. With respect to CDS trading, their  authorities are limited or restricted. In 1999, the PWG unanimously urged  Congress to adopt recommendations aimed at mitigating certain legal  uncertainties related to OTC derivatives. One recommendation was to  exclude from oversight certain bilateral transactions between  sophisticated counterparties and eliminating impediments to clearing OTC  derivatives. A CDS is this type of transaction. Congress largely adopted the  PWG recommendations when it passed the Commodity Futures  Modernization Act of 2000 (CFMA). As a result, the Commodity Exchange  Act (CEA) was amended to exclude the OTC CDS market from the  regulatory and enforcement jurisdiction of CFTC. Federal securities laws  also exclude CDS from SEC oversight, although SEC retains antifraud  enforcement authority.
SEC’s authority over CDS activity conducted outside of a registered  broker-dealer is generally limited to enforcing antifraud provisions,  including prohibitions against insider trading. These provisions apply  because CDS generally are considered security-based swap agreements  under CFMA. However, because SEC is generally statutorily prohibited  under current law from promulgating record-keeping or reporting rules  regarding CDS trading in the OTC market outside of a registered broker- dealer, its ability to enforce its authority is difficult. However, in the past 3  years SEC has initiated a number of CDS-related enforcement cases for  alleged violations of its antifraud prohibitions, including cases involving  market manipulation, insider trading, fraudulent valuation, and financial  reporting. More recently, in September 2008 SEC initiated an investigation  into possible market manipulation involving CDS. In connection with the  investigation, SEC announced that it would require certain hedge fund  managers and other entities with CDS positions to disclose those positions  to SEC and provide other information under oath. According to SEC,  depending on the results the investigation may lead to more specific policy  recommendations regarding CDS.
SEC officials indicated that investigations of OTC CDS transactions have  been far more difficult and time-consuming than those involving exchange- traded equities and options because of the prohibition on requiring  recording keeping and reporting for CDS. The lack of clear and sufficient  record-keeping and reporting requirements for CDS transactions has  resulted in incomplete and inconsistent information being provided when  requested, according to SEC officials. The officials said that this restriction  had made it more difficult to investigate and take effective action against  fraud and manipulation in the CDS market than in other markets SEC  oversaw. In October 2008, the SEC Chairman requested that Congress  remove the CFMA restrictions on SEC’s rulemaking authority with respect  to CDS. The current Chairwoman has indicted that she supports removal  of these restrictions as well.
section_title: Federal Regulators’ Approach to Monitoring Systemic Risk from CDS Has Hinged on Collaborative Efforts
paragraphs: Federal financial regulators have sought to address potential systemic  threats arising from CDS activities mainly through collaborative efforts  with other supervisors and market participants. According to federal  financial regulators, they address potential systemic risks by working  closely with each other and international regulators to exchange  information and coordinate the supervision of regulated market  participants that could pose systemic risks to the financial system. Some  of these collaborative forums include the PWG, the Senior Supervisors  Group, the Basel Committee on Banking Supervision, the Financial  Stability Forum, and the Joint Forum. However, it is unclear to what  extent the activities of unregulated subsidiaries or other unregulated  market participants were also being reviewed as part of these initiatives.
FRS officials indicated that, in carrying out its responsibilities for  conducting monetary policy and maintaining the stability of the financial  system, the Federal Reserve monitored markets and concentrations of risk  through data analysis and direct contact with market participants.  According to FRS officials, in supervising banks and bank holding  companies they focused on CDS activity as it pertained to institutional  stability. FRS ensures that the appropriate infrastructure is in place so that  the system can absorb “shocks.” FRS officials explained that, by ensuring  that important market participants could avoid the most adverse impacts  from these shocks—such as through counterparty credit risk  management—systemic risk could be mitigated.
Over the last several years, FRS has identified opportunities to increase  the market’s resiliency to systemic shocks related to CDS—for example,  by implementing a market process for settling CDS contracts, reducing the  notional amounts of outstanding contracts, and improving the operational  infrastructure of the CDS market in collaboration with other supervisors.  For example, since September 2005 financial regulators in the U.S. and  Europe have collaborated with the industry to improve the operational  infrastructure of the CDS market and to improve counterparty risk  management practices. However, some market participants and observers  noted that the current regulatory structure did not enable any one  regulator to monitor all market participants and assess potential systemic  risks from CDS and other types of complex products.
section_title: In the United Kingdom, FSA Generally Has Broader Authority Than U.S. Regulators Collectively
paragraphs: While U.S. regulators do not have authority over CDS as a product, in the  United Kingdom, where available evidence suggests CDS volume is  comparable to that in the United States, FSA has authority over most CDS  products. FSA officials explained that most CDS-related regulatory efforts  have been pursued in collaboration with U.S. regulators, such as the effort  to improve the operational infrastructure for CDS that was led by FRBNY  and the Senior Supervisors Group’s effort to enhance risk management  practices. FSA officials also explained that, more recently, it had been  monitoring all aspects of OTC infrastructure and industry commitments,  including central clearing for CDS, credit event settlement, collateral  management processes, trade compression, and position transparency.  Much of this monitoring is conducted through data collected directly from  regulated firms.
section_title: The New York State Insurance Supervisor Has a Role in Overseeing Insurers’ CDS Activities
paragraphs: The New York State insurance supervisor also has authority to oversee  certain aspects of insurers’ OTC derivatives activities, including CDS  transactions. According to the New York State Insurance Department, it  has regulated the use of derivatives by insurance companies, including  CDS, since the late 1990s. The Department is the primary regulator for  most U.S. financial guaranty insurers (FGIs), which are also known as  bond insurers. According to the Department, aside from FGIs few  insurance companies buy or sell CDS because New York state law  generally prohibits insurers from significantly leveraging their portfolios.  Insurance companies generally use CDS for hedging credit risk and for  investment purposes. According to department officials, in its role as  regulator for FGIs the department ensures that insurance companies  maintain consistent underwriting criteria and adequate reserves for these  activities. Under New York law, insurers must file detailed disclosures  about their derivatives transactions in their quarterly and annual  statements. Also, prior to engaging in any derivatives activity insurers  must file a derivatives use plan that documents their ability to manage  derivatives transactions. According to department officials, the  department has requested detailed information from FGIs and engages in  ongoing dialogue with them concerning insurance contracts referencing  CDS.
However, if an insurance company uses subsidiaries that are not affiliated  with the insurance company, oversight may be limited. For example, the  superintendent of the New York State Insurance Department testified that  it did not oversee the activities of AIG Financial Products because AIG  Financial Products was not affiliated with the insurance companies the  department regulates.
section_title: Risks and Challenges Presented by CDS and Other Financial Products
paragraphs: Risks to financial institutions and markets from CDS include counterparty  credit risk, operational risk, concentration risk, and jump-to-default risk.  However, market participants suggested that the degree of risk associated  with CDS varied depending on (1) the type of CDS, (2) the reference entity  for the CDS, and (3) how the CDS was used. More specifically, CDS  referencing ABS and CDOs, particularly those related to mortgages, were  identified as posing greater risks to institutions and markets than other  types of CDS. Other risks and challenges include the lack of transparency  in CDS markets, the potential for manipulation related to the use of CDS  as a mechanism for price discovery, and the use of CDS for speculative  purposes. Regulators and market participants noted that some OTC  derivatives may share similar risks. However, the degree of risk can vary  substantially by product type. Equity derivatives specifically were  identified as the OTC derivatives that were most similar to CDS in terms of  the risks and challenges that they presented.
subsections: section_title: Overview of the Risks and Challenges Posed by CDS
paragraphs: The main risks from CDS include counterparty credit risk, operational  risk, concentration risk, and jump-to-default risk. In simple terms,  counterparty credit risk is the risk to each party in an OTC derivatives  contract that the other party will not fulfill the obligations of the contract.  In addition to potentially not receiving contractual payments, a purchaser  of CDS whose counterparty fails would suddenly be left without  protection and could either have to replace the CDS contract at current,  higher market values or go without protection. Banks and other financial  institutions that have large derivatives exposures use a variety of  techniques to limit, forecast, and manage their counterparty risk, including  margin and collateral posting requirements.
However, regulators, market participants, and observers identified several  challenges in managing CDS counterparty credit risk. First, although  margin and collateral posting serve as a primary means of mitigating the  risk of loss if a counterparty does not perform on its contractual  obligations, calculating margin and collateral amounts can be difficult  because of the challenges associated with determining the actual amount  of counterparty exposure and the value of the reference asset. Specifically,  it may be difficult for market participants to agree on the valuation of CDS  contracts on ABS and CDOs. Second, margining practices are not  standardized and vary depending on the counterparty. For example,  market participants and observers suggested that institutions with high  credit ratings, for which exposures were considered to pose little credit  risk, were not initially required to post collateral. These firms included  bond insurers and AIG Financial Products, a noninsurance subsidiary of  AIG. However, when some of these institutions’ ratings were downgraded,  the institutions had difficulty meeting collateral calls. Third, the CDS  market lacks comprehensive requirements for managing counterparty  credit risk. More specifically, the bilateral collateral and margin  requirements for OTC derivatives do not take into account the  counterparty credit risk that each trade imposes on the rest of the system,  allowing systemically important exposures to build up without sufficient  capital to mitigate associated risks.
The second type of risk that I would like to discuss is operational risk.  This is the risk that losses could occur from human errors or failures of  systems or controls. With CDS, there are several operational steps that are  required to process trades, such as trade confirmation, which were not  automated until recently and thus created backlogs in the system. In a  report issued in 2007, we reported that these backlogs were largely due to  a decentralized paper-based system and the assignment of trades to new  parties without notifying the original dealer—a process known as  novation. For instance, in September 2005, some 63 percent of trade  confirmations (or 97,650) of the 14 largest credit derivatives dealers had  been outstanding for more than 30 days. These large backlogs of  unconfirmed trades increased dealers’ operational risk, because having  unconfirmed trades could allow errors to go undetected that might  subsequently lead to losses and other problems. Potential problems also  existed in the operational infrastructure surrounding physical settlement,  novation, and valuation of CDS.
The third type of risk, concentration risk, refers to the potential for loss  when a financial institution establishes a large net exposure in similar  types of CDS. For example, AIG presented concentration risk because it  sold a significant amount of CDS protection on related reference entities  without also holding offsetting positions and did not sufficiently manage  this risk. This risk tends to be greater for dealers that sell CDS protection  because no margin and collateral requirements exist to ensure that the  selling firm will be able to meet its potential obligations. Also, the  potential exposures are greater and more uncertain than the fixed  premium payments of a purchaser of CDS protection. Additionally, if a  market participant decides to hold a large concentrated position, it could  experience significant losses if a credit event occurred for one or more  reference entities. But concentration risk can create problems for market  participants even without a credit event involving the reference entity. For  example, a market participant may face obligations to post collateral on a  large net exposure of CDS if its financial condition changes, potentially  resulting in financial distress for the dealer. AIG is the most recent  example of this problem. When its credit rating was downgraded, the  contracts required that it post collateral, contributing to the company’s  liquidity crisis.
Market participants suggested that the degree of risk from concentrated  net exposures was tied to the nature of the reference entity or obligation.  For example, a concentrated position in CDS on mortgage-related CDOs  may present more risk than CDS on a highly-rated corporation or U.S.  government bonds. Further, concentration risks at one firm may also  present challenges to other market participants and the financial system.  According to a regulator and an observer, the lack of clear information on  the net CDS exposures of market participants makes informed decisions  about risk management difficult, a situation that becomes increasingly  problematic when a credit event occurs. A regulator also testified that  because the CDS market was interconnected, the default of one major  participant increased the market and operational risks faced by more  distant financial market participants and impacted their financial health.  The near-collapse of AIG illustrates the risk from large exposures to CDS.
Finally, jump-to-default risk, as it relates to the CDS market, is the risk that  the sudden onset of a credit event for the reference entity can create an  abrupt change in a firm’s CDS exposure. Such a credit event can result in  large swings in the value of the CDS and the need to post large and  increasing amounts of collateral and ultimately fund the settlement  payment on the contact. The default of a reference entity could put capital  strain on the CDS seller from increased collateral and payment obligations  to settle the contract. For example, because CDS generally are not funded  at initiation, a CDS seller may not have provided sufficient collateral to  cover the settlement obligations.
section_title: CDS Can Also Pose a Number of Other Risks and Challenges
paragraphs: Other risks and challenges from CDS identified by market participants,  observers, and regulators include a lack of transparency in the CDS  market, the potential for manipulation related to the use of CDS as a price  discovery mechanism, and the use of CDS for speculative purposes.  According to some regulators, market participants, and observers, limited  transparency or disclosure of CDS market activity may have resulted in  the overestimation of risk in the market. Such a lack of transparency may  have compounded market uncertainty about participants’ overall risk  exposures, the concentration of exposures, and the market value of  contracts. For example, as mentioned previously at least one regulator and  an observer suggested that it was unclear how the bankruptcy of Lehman  Brothers would affect market participants, and this uncertainty  contributed to a deterioration of market confidence. More specifically, it  was reported that up to $400 billion of CDS could be affected, but the  Depository Trust and Clearing Corporation (DTCC) later stated that its  trade registry contained $72 billion of CDS on Lehman, and this amount  was reduced to about $21 billion in payments after bilateral netting. Some  market participants suggested that concerns about transparency were  even more prevalent with customized CDS products because the contracts  were not standardized and their prices were determined using estimates  rather than prices from actual transactions.
Some regulators and an industry observer suggested the potential existed  for market participants to manipulate these prices to profit in other  markets that CDS prices might influence, such as the equity market, and  that the lack of transparency could contribute to this risk. CDS price  information is used by some market participants as an indicator of a  company’s financial health. Market participants use spreads on CDS  contracts to gauge the financial health and creditworthiness of a firm.  However, two regulators and an industry observer suggested that it was  unclear whether CDS prices accurately reflected creditworthiness because  the market was largely unregulated and the quality of data is questionable  in an opaque market. According to testimony by an SEC official in October  and November 2008, the lack of transparency in the CDS market also  created the potential for fraud, in part because the reporting and  disclosure of trade information to the SEC was limited. More specifically,  the official testified that a few CDS trades in a relatively low-volume or  thin market could increase the price of the CDS, suggesting that an entity’s  debt was viewed by the market as weak. Because market participants may  use CDS as one of the factors in valuing equities, this type of pricing could  adversely impact a reference entity’s share price. One market observer we  spoke with offered the following hypothetical example: if the CDS price  moves up and the equity price moves down, an investor could profit from  holding a short position in the equity by buying protection in the CDS  market. The SEC official testified that a mandatory system of record  keeping and reporting of all CDS trades to SEC should be used to guard  against the threat of misinformation and fraud by making it easier to  investigate these types of allegations. However, another regulator  suggested that the price discovery role was not a unique role to CDS and  that exchange-traded derivatives such as foreign exchange and interest  rate derivatives also served a price discovery function.
Another challenge identified by regulators and market participants was the  frequent use of CDS for speculative purposes, an issue that has raised  some concerns among some regulators and industry observers. Some have  suggested that the practice should be banned or in some way restricted.  However, other regulators and market participants disagree and note that  speculators in the CDS market provide liquidity to the market and  facilitate hedging. Many of the concerns stem from uncovered or “naked”  CDS positions, or the use of CDS for speculative purposes when a party to  a CDS contract does not own the underlying reference entity or obligation.  Because uncovered CDS can be used to profit from price changes, some  observers view their function as speculation rather than risk transfer or  risk reduction. For example, one regulatory official stated that these  transactions might create risks, because speculative users of CDS have  different incentives than other market participants. In addition, one  regulator stated that when participants used CDS for speculative purposes,  there was no direct transfer or swap of risk. Instead, the transaction  creates risk from which the participant aims to profit. Market participants  also noted that the risks associated with CDS did not stem from their use  for speculation but from a failure to manage the risks, particularly CDS of  ABS. Market participants and an observer also explained that a restriction  on uncovered CDS would create a market bias in favor of protection  buyers, because it is easier for them to hold a covered position. This bias  could impact the liquidity of the market, because trading would be  confined to those with an exposure to the referenced entity. Finally,  market participants noted that firms used CDS to manage risks from many  economic exposures in addition to risks such as counterparty credit  exposures that arise from holding the underlying reference obligation.
section_title: A Number of Other OTC Derivatives Pose Similar Risks and Challenges
paragraphs: In addition to CDS, we also explored whether other products posed  similar risks and challenges. Regulators and market participants identified  a number of other OTC derivatives that presented similar risks and  challenges, such as counterparty credit risk and operational risk. These  OTC derivative products include interest rate, foreign exchange, and  commodity derivatives. While the types of risk may be similar, the degree  of risk can vary. However, equity derivatives specifically were identified as  the OTC derivatives that are most similar to CDS in terms of the risks and  challenges that they presented. OTC equity derivatives, such as equity  swaps and options, were said to be similar to CDS because of the potential  for abrupt shifts in exposure, a lack of transparency, and the ability to  customize the product. Nevertheless, according to regulators and industry  observers, the CDS market differs from other OTC derivatives markets  because it poses greater risks due to the potential for greater increases in  payment obligations and larger impacts from life-cycle events such as  those associated with jump-to-default risk.
section_title: Regulators and the Industry Have Undertaken a Number of Initiatives Recently to Address Risks Posed By CDS and Other Financial Products
paragraphs: Financial regulators and the industry have initiated several efforts to begin  addressing some of the most important risks posed by CDS and similar  products, particularly operational and counterparty credit risks. These  efforts include improving the operational infrastructure of CDS markets,  implementing a clearinghouse or central counterparty to clear CDS trades,  and establishing a central trade registry for CDS. If implemented  effectively and sustained, the recent initiatives could begin to address  some of the risks related to the use of CDS. However, their effectiveness  will likely be constrained by two factors. First, participation in a  clearinghouse and central trade registry is generally voluntary. And  second, the efforts would not include the more customized and highly  structured CDS that can include CDS on complex reference entities that  may pose significant risks to institutions and financial markets. A number  of other reforms to the CDS market have surfaced but face challenges.  These include mandatory clearing or restricting CDS trades. Finally, OTC  derivatives that share some of the risks related to CDS could benefit from  similar efforts to mitigate their impact.
subsections: section_title: Actions Associated with Managing Risks Related to CDS Have Focused on Three Areas
paragraphs: Financial regulators and market participants have recently taken steps to  try to address risks posed by CDS. The efforts have focused on three main  areas: (1) operational and infrastructure improvements, (2) creation of a  central trade repository, and (3) development of clearinghouses to clear  CDS contracts.
subsections: section_title: Operational and Infrastructure Improvements
paragraphs: Regulators and industry members have cooperated since 2005 on four  projects to identify and address operational risks posed by CDS. In  addition to managing operational risks from CDS, several of these efforts  should assist participants in managing counterparty credit risks in general.
First, the industry has worked to reduce the backlog of CDS processing  events, including unconfirmed trades. In 2005, a joint regulatory  initiative involving U.S. and foreign regulators directed major CDS  dealers to reduce the backlog of unconfirmed trades and address the  underlying causes of these backlogs. In response, market participants  increased the use of electronic confirmation platforms. Since  November 2006, most CDS trades are confirmed electronically through  an automated confirmation system known as Deriv/Serv. By increasing  automation and requiring endusers to obtain counterparty consent  before assigning trades, dealers were able to significantly reduce the  number of total confirmations outstanding. As a result of these efforts  to improve trade processing, many participants view the CDS market  as the most automated among OTC derivatives.
Second, the industry has sought to improve novation, the process  whereby a party to a CDS trade transfers, or assigns, an existing CDS  obligation to a new entity. In 2005, the joint regulatory initiative  suggested that the novation process had contributed to the large  backlog of unconfirmed trades, because the assignment of trades to  new parties often occurred without the consent of the original  counterparty. In such cases, a party to a CDS contract might not be  aware of the identity of its new counterparty, possibly increasing  operational and counterparty credit risks. To streamline the novation  process, ISDA introduced a novation protocol in 2005 that required  counterparty consent before assigning a trade. However, until recently  parties to the novation communicated using phone and e-mail, both of  which can be inaccurate and inefficient. More recently, the industry has  committed to processing all novation consents for eligible trades  through electronic platforms.
Third, the industry has attempted to reduce the amount of outstanding  trades via “portfolio compression.” In 2008, a Federal Reserve initiative  resulted in a working group of dealers and investors that  collaborated with the industry trade group ISDA to pursue portfolio  compression of CDS trades. The process involves terminating an  existing group of similar trades and replacing them with fewer  “replacement trades” that have the same risk profiles and cash flows as  the initial portfolio, and thus eliminating economically redundant  trades. According to FRBNY, the compression of CDS trades results in  lower outstanding notional amounts and helps to reduce counterparty  credit exposures and operational risk. By the end of October 2008,  FRBNY reported that trade compression efforts had reduced the  notional amount of outstanding CDS by more than one-third.
Finally, the industry has taken steps to implement a cash settlement  protocol for CDS contracts. CDS contracts traditionally used physical  settlement that required a protection buyer to deliver the reference  obligation in order to receive payment. Because many CDS are  uncovered, the protection buyer would have to buy the underlying  referenced entity to deliver, potentially causing buyers to bid up prices  and limiting the profits from protection and speculation. To address  this concern, ISDA developed protocols to facilitate cash settlement of  CDS contracts. The cash settlement protocols rely on auctions to  determine a single price for defaulted reference obligations that is then  used to calculate payout amounts to be paid at settlement. This process  has been used to settle CDS contracts involved in recent credit events,  including Lehman Brothers, Washington Mutual, Fannie Mae, and  Freddie Mac.
section_title: Creation of a Central Trade Repository Illustrates the Limits of a Voluntary System
paragraphs: In November 2006, DTCC created the TIW to serve as the industry’s  central registry for CDS. TIW contains an electronic record of most CDS  trades, and DTCC and market participants plan to increase its coverage. In  addition to placing most new trades in TIW, CDS dealers and other market  participants also plan to submit existing and eligible CDS trades to TIW.
TIW helps to address operational risks and transparency concerns related  to the CDS market. For example, according to DTCC, it helps mitigate  operational risk by reducing errors in reporting, increases transparency by  maintaining up-to-date contract information, promotes the accuracy of  CDS-related information, and simplifies the management of credit events.  TIW also facilitates operational improvements such as automated life- cycle processing by interacting with electronic platforms for derivatives  trades such as Deriv/Serv.
Additionally, TIW should assist regulators in monitoring and managing  concentration risk from CDS. Although regulators can receive CDS-related  information from their regulated entities, no regulator has the ability to  receive this information from all market participants, and no single  comprehensive source of data on the CDS market exists. However, a  central trade repository that contains information on all CDS trades will  allow regulators to monitor large positions of market participants and  identify large and concentrated positions that may warrant additional  attention. TIW also has helped to address some concerns about CDS  market transparency by providing aggregate information on CDS trades.  The information includes gross and net notional values for contracts on  the top 1,000 underlying CDS single-name reference entities and all  indexes and is updated weekly.
Despite the important benefits provided by TIW, several factors limit its  usefulness as a tool to monitor the overall market. First, TIW does not  include all CDS trades, particularly those that cannot be confirmed  electronically. For example, TIW cannot fully capture all customized  trades, such as CDS referencing ABS and CDOs, including those related to  mortgages. While DTCC officials believed that TIW includes a large  portion of CDS trades, they noted that they could not be certain because  the size and composition of the entire market remain unknown. Second,  TIW currently has no regulatory oversight to ensure the quality of the data,  and regulators lack the authority to require that all trades be included in  TIW, particularly those of nonbanks.
section_title: Clearinghouses May Offer Some Benefits, but Some CDS May Be Too Customized for Clearing
paragraphs: A clearinghouse can reduce risks associated with CDS, including  counterparty credit risks, operational risks, and concentration risks, while  also improving transparency. A clearinghouse acts as an intermediary to  ensure the performance of the contracts that it clears. For CDS, market  participants would continue to execute trades as bilateral OTC contracts.  However, once registered with the clearinghouse the CDS trade would be  separated into two contracts, with the clearinghouse serving as the  counterparty in each trade. That is, the clearinghouse would have a  separate contractual arrangement with both counterparties of the original  CDS contract and serve as the seller to the initial buyer and the buyer to  the initial seller. In this way, a clearinghouse would assume the  counterparty credit risk for all of the contracts that it cleared.
If a clearinghouse is well-designed and its risks are prudently managed, it  can limit counterparty credit risk by absorbing counterparty defaults and  preventing transmission of their impacts to other market participants.  Clearinghouses are designed with various risk controls and financial  resources to help ensure that they can absorb counterparty failures and  other financial losses. For example, clearinghouses impose standard  margin requirements and mark positions to market on a daily basis. They  also have other financial safeguards that typically include capital  requirements, guaranty funds, backup credit lines, and the ability to call on  capital from member firms, which often are large financial institutions.
A clearinghouse also can help to standardize margin and collateral  requirements. It can impose more robust risk controls on market  participants and assist in the reduction of CDS exposures through  multilateral netting of trades. In doing so, it would facilitate the  compression of market participants’ exposures across positions and  similar CDS products, thereby reducing the capital needed to post margin  and collateral.
A clearinghouse also can help to address operational and concentration  risks and improve CDS transparency. Market participants suggested that a  clearinghouse would help to centralize market information and could  facilitate the processing of CDS trades on electronic platforms. It can also  help limit concentration risk through standardized requirements for  margin collateral that may help reduce the leverage imbedded in CDS  contracts and thus place limits on a firm’s ability to amass a large net  exposure selling CDS. Finally, according to some regulators and  prospective clearinghouses, a clearinghouse could improve CDS  transparency by releasing information on open interest, end-of-day prices,  and trade volumes.
However, like the other options for improving the CDS market, only  certain standardized trades would be cleared by a clearinghouse, and  market participants would decide which trades to submit for clearing. A  clearinghouse can only clear trades with a sufficient level of  standardization because the more customized the contract, the greater the  risk management and operational challenges associated with clearing it.  Initially, the proposed clearinghouses will clear standard-index CDS and  some highly traded single-name corporate CDS. Regulators and market  participants suggested that risks from more complex and structured CDS  would have to be addressed outside of clearinghouses. One market  participant volunteered that it would not be opposed to collateral  requirements for CDS that were not cleared through a clearinghouse.  Further, because clearing is voluntary, it is unclear what portion of CDS  will be cleared and whether this volume will be sufficient to support the  clearinghouses.
Regulators and market participants suggested that robust risk  management practices were critical for clearinghouses because  clearinghouses concentrated counterparty credit and operational risk and  CDS presented unique risks. Failure to sufficiently manage these risks  could threaten the stability of financial markets and major institutions if a  clearinghouse were to fail. In addition, if jump-to-default risk is not  sufficiently managed through margin requirements and other methods, it  has the potential to create significant losses for the clearinghouses.  According to market participants, the jump-to-default risk posed by CDS  makes determining sufficient margin requirements difficult. If a required  level of margin is considered too high, whether justified or not, market  participants may be less likely to use the clearinghouse.
Although several groups have announced plans to create clearinghouses  for CDS, none of the groups currently are clearing trades. First, as part of  their efforts over the past year to improve the CDS market, FRBNY and  several other regulators encouraged the industry to introduce central  clearing of CDS contracts. The industry previously had begun moving  toward the creation of a clearinghouse, and in July 2008, after FRBNY  encouraged firms to develop clearinghouse proposals, several major  dealers committed to launching a clearinghouse by December 2008. None  are currently operational, however. At least four groups have developed  clearinghouse options for CDS, two in the United States  (IntercontinentalExchange and CME Group) and two in Europe (LIFFE  and Eurex Clearing). LIFFE opened for clearing in December 2008 but has  had virtually no business as of February 2009.
Market participants and regulators identified advantages and  disadvantages associated with having multiple clearinghouses clear CDS  contracts. Some regulators noted that there could be advantages to having  multiple clearinghouses at the early stages of development, particularly  related to competition in designing and developing them. In addition, one  market participant noted that with multiple clearinghouses the  concentration of risk could be spread across multiple platforms. However,  market participants suggested that having multiple clearing houses raised  concerns about regulatory consistency in terms of setting standards and  monitoring, especially for those in the U.S. and internationally. Market  participants also indicated that multiple clearinghouses would create  inefficiencies and remove some of the advantages gained from multilateral  netting, because no single clearinghouse would enjoy the benefit of a  complete portfolio of CDS. Moreover, participants would have to post  collateral in multiple venues.
Under current law, a clearing organization for CDS—or other OTC  derivatives—must be regulated, but any of several regulators may provide  that oversight. FRS, CFTC, and SEC all have played a role in establishing a  clearinghouse, including reviewing proposals seeking regulatory approval.  CME is registered as a derivatives clearing organization with CFTC. ICE  has established its clearinghouse in a subsidiary FRS member bank—ICE  Trust. LIFFE is regulated by FSA, and Eurex is overseen by the German  Federal Financial Supervisory Authority.
SEC has determined that the act of clearing CDS through a clearinghouse  may result in the contracts being considered securities subject to the  securities laws. To facilitate the clearing and settlement of CDS by  clearinghouses, SEC issued an interim final rule on temporary and  conditional exemptions in January 2009. SEC stated that the conditions of  these exemptions would allow the agency to oversee the development of  the centrally cleared CDS market and CDS exchanges and to take  additional action as necessary. SEC has determined that LIFFE has met  the conditions for the temporary exemptions from registration under the  securities laws. The exemption expires in September 2009, at which time  SEC officials believe they will be better situated to evaluate how these  exemptions apply to the cleared CDS market.
Given the overlapping jurisdiction and lack of regulatory clarity, FRS,  CFTC, and SEC have signed a memorandum of understanding to ensure  that each regulator applies similar standards across the different  clearinghouse efforts. According to the regulators, the purpose of the  memorandum is to foster cooperation and coordination of their respective  approvals, ongoing supervision, and oversight of clearinghouses for CDS.  Moreover, some said that the memorandum would help to prevent an  individual regulator from taking a softer approach in its monitoring and  oversight of required standards for clearinghouses, which could encourage  more participants to use the less rigorously regulated clearinghouse.  However, another regulator suggested that the memorandum still might  not guarantee consistent application of clearinghouse standards and  requirements, because each regulator had a different mission and  approach to regulation.
Market participants identified several disadvantages related to the current  state of oversight for clearinghouses. Some market participants suggested  that there had been a lack of clarity and certainty regarding oversight of  clearinghouses because of the involvement of multiple regulators. As  noted, some market participants questioned whether consistent standards  and oversight would be applied across clearinghouses. Market participants  and one regulator noted the importance of coordinating oversight  internationally to ensure consistent global standards and mitigate the  potential for regulatory arbitrage. Finally, some market participants  suggested that having multiple regulators for a clearinghouse created the  potential for regulatory overlap and related inefficiencies.
section_title: Other Ideas to Manage CDS Risks
paragraphs: Market observers and others have proposed other ideas to address  concerns related to CDS, including (1) mandatory clearing, (2) mandatory  exchange trading, (3) a ban on uncovered CDS, and (4) mandatory  reporting of CDS trades. While these proposals would address some  perceived problems with CDS markets, sources we interviewed identified  important limitations and challenges for each of them.
Mandatory clearing would ensure that CDS contracts benefited from the  advantages of a clearinghouse, but regulators, market participants, and  market observers explained that highly customized CDS would be  impossible to clear because they lack the needed standardization.
Mandatory exchange trading could offer improved price transparency and  the benefits of clearing. But some market observers indicated that some  CDS that were illiquid could not support an exchange and that the  standardization of contracts would limit CDS’ risk management benefits.
Banning or otherwise restricting uncovered CDS could limit activity that  some observers believe contributed to the recent distress of financial  institutions, yet proponents of uncovered CDS argue that banning these  contracts would severely limit market liquidity and eliminate a valuable  tool for hedging credit risk.
Finally, some regulators and market observers believe that mandatory  reporting of CDS trades to a central registry would increase transparency  and provide greater certainty that information on all CDS was being  captured in one place. However, some market participants suggested that  detailed reporting of CDS trades should be limited to regulators so that  positions were not exposed publicly, and some participants explained that  a similar reporting system for bond markets had had adverse  consequences that stifled that market.
section_title: Other OTC Derivatives May Benefit from Similar Efforts
paragraphs: Regulators and the industry have initiated efforts to improve the  operational infrastructure of OTC derivatives in general. However, each  product has unique challenges because of differences in market maturity,  volumes, and users, among other things. Despite these unique challenges,  regulators, market participants, and observers told us that OTC  derivatives, generally shared similar risks, such as operational and  counterparty credit risks, and would benefit from initiatives to address  those risks. As part of their efforts to improve the operational  infrastructure of OTC derivatives markets, market participants have  identified seven high-level goals:
Global use of clearinghouse processing and clearing,
Continuing portfolio compression efforts,
Electronic processing of eligible trades (targets of the effort  include equity, interest rate, and foreign exchange derivatives),
Elimination of material confirmation backlogs,
Risk mitigation for paper trades that are not electronically
Streamlined trade life-cycle management, and
Central settlement for eligible transactions.
Some other OTC derivatives may also benefit from reductions in the  amount of outstanding trades through portfolio compression efforts.  FRBNY officials stated that they are looking at other OTC derivatives that  had a critical mass of outstanding trades to determine whether they would  benefit from compression. To the extent that further regulatory actions are  explored for other OTC derivatives, regulators must consider the risks and  characteristics of each class of OTC derivatives before taking additional  actions.
In closing, I would like to provide some final thoughts. While CDS have  received much attention recently, the rapid growth in this type of OTC  derivative more generally illustrates the emergence of increasingly  complex products that have raised regulatory concerns about systemic  risk. Bank regulators may have some insights into the activities of their  supervised banks that act as derivatives dealers, but CDS, like OTC  derivatives in general, are not regulated products, and the transactions are  generally not subject to regulation by SEC, CFTC, or any other U.S.  financial regulator. Thus, CDS and other OTC derivatives are not subject  to the disclosure and other requirements that are in place for most  securities and exchange-traded futures products. Although recent  initiatives by regulators and industry have the potential to address some of  the risks from CDS, these efforts are largely voluntary and do not include  all CDS contracts. In addition, the lack of consistent and standardized  margin and collateral practices continue to make managing counterparty  credit risk and concentration risk difficult and may allow systemically  important exposures to accumulate without adequate collateral to mitigate  associated risks. This area is a critical one and must be addressed going  forward.
The gaps in the regulatory oversight structure of and regulations governing  financial products such as CDS allowed these derivatives to grow  unconstrained, and little analysis was done on the potential systemic risk  created by their use. Regulators of major CDS dealers may have had some  insights into the CDS market based on their oversight of these entities, but  they had limited oversight of nonbank market participants, such as hedge  funds, or subsidiaries of others like AIG, whose CDS activities partly  caused its financial difficulties. This fact clearly demonstrates that risks to  the financial system and even the broader economy can result from  institutions that exist within the spectrum of supervised entities. Further,  the use of CDS creates interconnections among these entities, such that  the failure of any one counterparty can have widespread implications  regardless of its size. AIG Financial Products, which had not been closely  regulated, was a relatively small subsidiary of a large global insurance  company. Yet the volume and nature of its CDS business made it such a  large counterparty that its difficulty in meeting its CDS obligations not  only threatened the stability of AIG but of the entire financial system as  well.
Finally, I would briefly like to mention what the current issues involving  CDS have taught us about systemic risk and our current regulatory system.  The current system of regulation lacks broad authority to monitor,  oversee, and reduce risks to the financial system that are posed by entities  and products that are not fully regulated, such as hedge funds, unregulated  subsidiaries of regulated institutions, and other non-bank financial  institutions. The absence of such authority may be a limitation in  identifying, monitoring, and managing potential risks related to  concentrated CDS exposures taken by any market participant. Regardless  of the ultimate structure of the financial regulatory system, a systemwide  focus is vitally important. The inability of the regulators to monitor  activities across the market and take appropriate action to mitigate them  has contributed to the current crisis and the regulators’ inability to  effectively address its fallout. Any regulator tasked with a systemwide  focus would need broad authority to gather and disclose appropriate  information, collaborate with other regulators on rule making, and take  corrective action as necessary in the interest of overall financial market  stability, regardless of the type of financial product or market participant.
section_title: Staff Contact and Acknowledgments
paragraphs: For further information about this testimony, please contact Orice M.  Williams on (202) 512-8678 or at williamso@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found on  the last page of this statement. Individuals making key contributions to  this testimony include Karen Tremba, Assistant Director; Kevin Averyt,  Nadine Garrick, Akiko Ohnuma, Paul Thompson, and Robert Pollard.
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