Regulating Credit Default Swap

Regulation of Credit Default Swap (CDS) is probably the most contentious topic in terms of the global financial reform in the post-crash economy. Some people believed CDS is the main cause of the Global Financial Crisis, and conceived it as simply a form of speculation or, to put more explicitly, a gamble. I am not going to argue for any side but just would like to express some thoughts on the recent regulatory reforms on CDS.

CDS indeed helped to grow and spread the systemic risk through out the financial system by promoting the securitization and the housing bubbles, escalating the interconnectedness among “too big to fail” financial institutions, and removing the transparency from the financial market. Through the CDS, banks can easily hedge and insure their risk against the default in their positions of mortgaged-backed securities (MBS) and collateralized debt obligations (CDO) that invested in MBS. Such insurance encourage the brokers and bank take greater risks through making large scale of residential loans without carefully evaluating the property owners’ credit and repaying abilities and thus failed in preventing the stimulation of the housing bubble of 2008.

CDS regulation differs a lot from other derivatives. Under the Commodity Futures Modernization Act of 2000 in U.S, the CDS was explicitly excluded from both the CFTC and SEC regulation. CDS basically traded over the counters (OTC) and is free of disclosing any trading information including the collaterals and the terms of their CDS agreements. This makes the CDS market as essentially an unregulated market, only some trade repository, such as the ISDA will provide standardized agreement and record those agreements in an almost secret and so called “self-regulated” manner.

In addition, through the repeal of the common law rule called “rule against difference contracts”, the default of the counterparty in a transaction is enforceable. Such dramatic change to certain extent encouraged the use of CDS and discouraged the transacting party from doing their best to monitor and manage the counterparty default risk. Still, the CDS can enjoy some special treatment that enable the creditors can immediately grab and sell any collateral they have if their counterparty files for bankruptcy. All the characters make it possible for institutions like AIG and Lehman to lose very large amounts of money in an unexpected way.

The most prominent figure that addressed the regulation of CDS mostly may be the new regulatory perimeter proposed by the Dodd-Frank Act in U.S. The Dodd-Frank Act addressed both the infrastructure of the derivatives markets and the regulation and supervision of its deals and major participants. The Act separates the jurisdiction over the swap and securities-base swap to CFTC and SEC respectively, and requires a swap should be cleared in a clearinghouse and traded in an exchange in order to mitigate the counterparty credit risk though the way of creating one or several central counterparties. Besides, by enforcing the swap push out rule (a sister provision of the famous Volcker Rule), the regulators can force insured depository institutions move certain swap operations out of the depository unit so that they would not threaten customers’ bank deposits.

Despite of the efforts the U.S regulators put in addressing the CDS reform, there are still some aspects that I believe can be better done. First, the Act fails to address the concentration risk that may be incurred by the clearing house. If we encourage a single clearing house, then the house itself is too big to fail. The failure of that house will impose huge costs and systemic risk to global financial system. But if we require multiple clearing houses, then they may compete for business by lowering their standards, such as setting improper low margin or collateral requirements. Second, because CDS contracts are designed as mark-to –market daily and every gain or lose will be covered by collaterals, the movements in market rates and the change or adjustment of the debt rating will trigger large cash requirement and thus in turn would bring the liquidity risk to the market. Third, the Act addresses the opaque documentary issues insufficiently. Even though swap dealers and participants under the new Dodd-Frank regime are required to register with the CFTC and the volume and prices of every swap should be reported, the U.S and global regulators still failed to target the big tiger “ISDA”, and the related issues such as requiring them to freely disclose the contents of their master agreements and allowing the worldwide scholars and practitioners freely use, revise and develop those agreements.

Even though all the proposals were addressed, maybe the most direct and effective way, although may not be the once-and-all cure-all, to mitigate the systemic risk that created and dampened by CDS is refusing to enforce the OTC CDS that was not transacted with a true hedging purpose, namely, the return of the old common law rule. Through making the CDS contracts back to the unenforceable nature, the transacting parties will not only try their best to mange the potential counterparty risk but also try to prevent themselves from defaults in order to build up good reputation to further reduce the transaction costs and increase their competitive advantages. The rule against difference contracts could preserve the economic benefits of hedging transaction while at the same time discouraging the large scale, unrestrained speculation that CDS has been heavily criticized for a long time.