As Congress and the Obama Administration consider changes
in financial market regulation, much attention is focused on once
obscure and still poorly understood financial instruments known as
credit default swaps (CDSs). The House Agriculture Committee
has approved legislation that would restrict who may own CDSs and
where they may be traded. The Obama Administration has proposed
requiring that CDS contracts be settled through clearinghouses
rather than directly between the contracting parties.
Meanwhile, in the real world outside of Washington, the
institutions that make and manage CDS markets are completing a
series of changes that will make global credit markets more
transparent, efficient, and stable--everything regulation
promises but rarely delivers. On March 9, a new clearinghouse
began processing CDS trades. On April 8, CDS trading conventions
were transformed in a "big bang" arranged by the International
Swaps and Derivatives Association (ISDA), the trade
association of derivatives dealers.
In combination, these developments make the CDS market safer,
more transparent, and more liquid. These private-sector
changes will deliver or facilitate most of the benefits sought
through proposed regulation, but in a way that will preserve the
vitality and utility of a critical national and international
These reforms occurred with a nudge from regulators, but
the private-sector execution and likely success of these
reforms is a model for further reform of financial regulation. CDS
market developments provide three important regulatory lessons that
can be applied across financial markets.
- Policymakers should encourage market reforms for market
problems. Markets themselves will often correct
deficiencies far more rapidly than regulators. This does not mean
that regulation has no place; it means that regulators can often
act most effectively by encouraging private parties to devise
market solutions to market problems whenever possible rather than
by dictating nonmarket solutions.
- Policymakers should consider how existing regulation
contributed to market deficiencies. Instead of automatically
assuming that more regulation is required, policymakers should
carefully review the causes of market disruptions. In many
cases, rationalizing existing regulations will contribute more
to market stability than new rules or regulatory bodies can. In
fact, layering new regulations and agencies on the outdated and
obviously failed structure that exists today could lead to further
market dysfunction. Overregulation is as dangerous as
underregulation, but overregulation is harder to identify and
- Rules should be flexible to allow for and react to changes
in markets. Markets evolve. They cannot be created or run by
government, although they are shaped by regulation. The incentive
effects of regulation are too often ignored as a tool and byproduct
Congress should facilitate the ongoing market and regulatory
evolution of credit derivatives markets rather than
reflexively imposing regulation or insisting that markets conform
to government jurisdictional categories.
Derivatives are financial instruments that have a value based on
the price of something else. Two common forms of derivatives are
futures and options. Using these products, a farmer can plant grain
in June and know the price that he will receive for it in September
because he has already sold the crop in the futures market.
Similarly, an airline can sell tickets six months in advance and
know its costs because it has used an option contract to limit the
price it will pay for jet fuel.
Financial derivatives, which have values related to underlying
financial exchanges, are similarly useful. For instance,
investors can "swap" variable payments for fixed income
without selling the underlying asset. One side of the transaction
values predictable payments; the other is willing to bear the risk
in return for the profit potential of variations in the income
Credit default swaps are financial derivatives that operate like
insurance on bonds or other debt. One party pays a periodic
premium, and the other party promises to make good on the debt in
the event of a "credit event," such as missed payments or
bankruptcy. This type of transaction is valuable because it
can reduce the risk faced by bondholders or other creditors.
Credit Default Swaps
Credit default swaps were developed as a way for lenders to
transfer the risk that a loan would not be repaid without
transferring the underlying loan. Banks can find it difficult or
impossible to sell loans because of restrictions in loan
agreements, concern for a larger relationship with the borrower, or
the simple lack of a market for individual loans. CDSs addressed
these difficulties by preserving the original loan while
transferring the associated repayment risk. CDSs were also used to
facilitate the packaging of multiple loans into securities that are
more readily marketable than individual loans.
A principal reason for the rapid growth in CDSs was the adoption
of mark-to-market accounting and capital requirements in the United
States and internationally through the Basel bank capital
requirements. Under historic value accounting, a bank or other
regulated entity could buy a bond, earn interest, and count the
principal amount paid for the bond as regulatory capital.
However, bond prices fluctuate in response to changes in
interest rates and changes in the borrower's financial status.
Under mark-to-market accounting, these fluctuations must be
recognized on a continuing basis. A bondholder might be required to
post additional capital or suffer a downgrade in its own
credit, even without any real loss on the bonds. This caused a
number of bond buyers to switch from traditional bond insurance,
which covers losses but is not marked to market, to CDSs, which are
marked to market. Because CDS values vary inversely with the
value of the reference entity's bonds, banks can use CDSs to smooth
out fluctuations in their regulatory capital accounts.
The use of CDSs also grew rapidly because they were adaptable
for a variety of uses. The market grew quickly to include swaps on
a corporation's total debt ("single names") and on broad indexes of
corporate debt and other types of securities.
Banks and bondholders are not the only creditors in the
marketplace. Landlords are creditors to tenants. Suppliers are
creditors to customers. A landlord can use CDSs to protect
against the risk of a tenant's failing to pay rent. Swaps have been
written on individual leases, but a landlord can also buy a swap on
a tenant's overall debt or even on a class of debt, such as that of
retail merchants, and secure a reasonable hedge against a tenant's
default. Companies entering into long-term supply contracts
with business partners can similarly protect themselves against a
partner's failure by using CDSs.
CDSs are also used increasingly to assess creditworthiness
and credit risk. Bond rating agencies have been widely discredited
in the wake of the market meltdown. CDSs provide a market measure
of a firm's credit risk. Moreover, a creditor who wishes to do so
can actually buy a CDS to hedge risk. A bond rating provides no
Did Credit Derivatives Cause the
Some commentators have suggested that CDSs were a cause of the
recent market crisis. Dissecting these claims can be difficult
because the criticisms are misinformed or inconsistent. Warren
Buffett famously described CDSs as "weapons of financial mass
destruction" in Berkshire Hathaway's 2002 annual report.
However, Buffett recently admitted that his company has sold
at least 251 derivative contracts with a total face value of
more than $14 billion. Buffett says he plans to continue
selling CDSs because "the odds strongly favor making money."
Specific criticisms of CDSs fall into four categories:
- The size of the CDS market threatens the economy,
- CDSs are used to manipulate markets,
- CDSs created excessive risk, and
- CDSs contributed to the freeze-up in credit markets.
Some of these criticisms are simply misinformed. In other
cases, reforms in CDS markets, such those recently implemented in
the private sector, rather than more regulation is the most
Market Size. New York Insurance Commissioner Eric
Dinallo, one of the loudest critics of CDSs, argued that the size
of the CDS market was a threat to the economy by comparing the face
value of outstanding CDS contracts with the size of the U.S.
private-sector debt: about a 4:1 ratio. Regrettably,
Dinallo, who ought to know better, fundamentally misrepresents the
CDS market. For one thing, the CDS market encompasses European and
international corporate debt and mortgage securities, not just
U.S. bonds, and includes sovereign debt of the U.S. and other
nations. The week Dinallo made his charge, the largest individual
debtor named in outstanding CDS contracts was the Republic of
Italy, not a U.S. corporation.
Moreover, the face value of CDSs is deceptive because the
over-the-counter CDS market is largely bilateral. When participants
want to change their CDS investment mix, they usually write new
contracts rather than buy, sell, or cancel existing
contracts. For instance, a bank might sell $100 million in
protection on a particular type of debt and then later buy $90
million in protection on the same debt to hedge its position. The
bank would report $190 million in outstanding contracts even
thought its net exposure was only $10 million.
To the extent that the high "notional value" is perceived as a
problem, market participants have already begun to address the
issue through a series of "compression" efforts by matching and
eliminating offsetting trades within a related series. The
ongoing migration of trades to the CDS clearinghouse will
greatly facilitate this effort. The need to write offsetting trades
to change market positions will be further reduced by the "big
bang" convention changes, which will make CDSs more
standardized and more readily tradable.
In combination, these market developments are likely to reduce
the notional-to-net ratio significantly.
Market Manipulation. Richard Fuld, former chief executive
officer of Lehman Brothers, fingered CDS sales as partly
responsible for his firm's failure. Some evidence indicates that
non-CDS transactions-- "short" sales of stock--may have contributed
to Lehman's failure. However, CDSs are related to the debt of a
corporation, not its equity (stock). Moreover, CDS contracts are
often settled for cash rather than through an exchange of debt
securities (physical settlement), making it difficult to posit a
causal link between CDS trades and the company's failure.
Of course, CDS trading reflects investors' views of a company's
health, but this is a measure of sentiment, not a cause of
corporate ills. The effect of market psychology on prices is hardly
unique to the CDS market. Blaming CDSs for corporate debt problems
is like blaming the thermometer for the temperature.
To the extent that market manipulation does occur--through CDSs
or other mechanisms--it is already illegal, both as common-law
fraud and under federal securities statutes. Processing trades
through a central clearinghouse that is regulated by the Federal
Reserve and the Securities and Exchange Commission (SEC) will make
it easier for regulators to monitor and review trading activity if
an investigation is necessary.
Risk Allocation. Insurance giant AIG clearly
misunderstood and misallocated risks associated with its CDS
trades. However, the miscalculation was related to the
mortgage-backed securities that AIG guaranteed through its trades.
Like many mortgage investors, AIG believed that home prices
were unlikely to decline and that any declines would be
"uncorrelated" (limited to discrete areas rather than affecting the
entire housing market at once).
CDS trading practices that prevailed until recently facilitated
AIG in taking risky bets on the housing market.
- First, prices in the over-the-counter CDS market were
not readily available, giving AIG and similarly situated
parties little external feedback about appropriate pricing.
- Second, the prevailing margin practices allowed AIG to
write CDS contracts without posting margins or reserves
Once more, recent market developments have begun to address
these problems. New CDS trading conventions include standard
contract dates, uniform pricing methods, and improved resolution
procedures. These changes will make the market broader and
more liquid, providing better pricing information. Central
clearinghouses will collect and enforce margin requirements and
scrutinize market positions. Because each clearinghouse member
ultimately stands behind trades made through it, members will
monitor trading positions to prevent excessive risk concentrations
or insufficient margin reserves.
Credit Contraction. "Counterparty risk"--the possibility
that a contractual partner will fail to pay what is owed--is a
significant concern in any financial transaction, including
garden-variety loans and bank deposits. The risk that a party may
not pay cannot be eliminated: CDSs allow the risk to be
transferred, but transferring a risk does not magnify it.
In September 2008, world financial markets experienced an
historic credit freeze. The contraction was not limited to CDS
markets. For instance, investors withdrew $210 billion from money
market funds in a two-day period after one fund failed due to
overexposure to Lehman Brothers debt. Critics charge that
uncertainty about CDS obligations combined with the long
chains of obligations involved in many CDS trades may have
triggered or intensified this credit crisis.
Compared to public markets (such as stock markets), the
over-the-counter CDS market was opaque because pricing and volume
information was not readily available, less efficient because of
the large volume of contracts and relatively slow settlement
process, and more subject to counterparty risk. Large numbers of
CDS contracts were written on mortgage-related debt. When the
housing market decline triggered claims, CDS market imperfections
arguably contributed to three problems.
- Some companies, such as AIG, mispriced products and
underestimated risks and had difficulty honoring contracts that
they had written.
- The complex, opaque nature of the CDS market may have
contributed to the credit freeze by making lenders less willing to
advance funds to borrowers who might be exposed to bad debt, such
as Lehman Brothers debt.
- The need for CDS-protection sellers to find collateral to
meet unanticipated claims may have contributed to declines in
equity (stock) markets.
In summary, critics of CDSs claim that rather than limiting risk
as intended, the CDS market actually spread risk. While these
claims are hotly disputed, it is important that these
criticisms do not refute the beneficial uses of CDSs. Rather, they
point to imperfections in the market affecting price
discovery, assurance of payment, and collateralization. Thus,
improving rather than restricting the CDS market is the appropriate
remedy for these problems.
The Options for Trading Financial
CDSs are bilateral contracts negotiated directly between
parties. Certain brokers and services help to match interested
buyers and sellers, but final negotiations are typically through
one-to-one telephone or e-mail communications. Until now,
financial settlements were also made directly between the
parties, and the result has sometimes been disputes, delays, and
uncertainty. Proposals to reform the CDS market include
requirements for central clearing or exchange trading.
With central clearing, arrangements for trades are still made
bilaterally (over the counter), but a financial intermediary
handles financial exchanges to complete the contract. This service
is similar to a real estate escrow arrangement, except that it
continues through the life of a CDS contract (typically five
years). Central clearing reduces mistakes, disputes, and
uncertainty in financial transactions.
Exchange trading involves bids and offers to anonymous parties
in a widely traded market. Trades are made between a buyer or
seller and a market specialist rather than directly between buyer
and seller. Exchange trading requires a large market with frequent
trades. For instance, most U.S. stocks are now traded on exchanges,
but bonds and other less widely traded instruments lack sufficient
volume to make exchange trading practical.
The CDS Market's Imperfections
Critics have decried the unregulated nature of the CDS market.
Yet in considering what, if any, new regulation is needed, it is
important to understand that the CDS market has evolved like all
other markets. Creating a CDS market as a full-blown exchange would
have been impossible, just as the traders who met outdoors on Wall
Street in the 19th century or made small stock trades
individually over the telephone in the 1970s could not have
created the New York Stock Exchange or NASDAQ Stock Market in their
times. In fact, the inflexibility of the U.S. financial regulatory
structure is one important reason why the CDS market evolved
While CDSs are similar to several other financial products, they
do not fit neatly into the regulatory structure, which was
developed largely in the 1930s. CDSs are similar to insurance, but
certain CDS features, such as payments to a party who has not
suffered an actual loss, would be illegal if offered as insurance.
CDSs are also similar to futures, but commodity laws require
futures to be traded exclusively on exchanges. Exchange
trading requires standard contracts, but some CDSs are highly
customized, making it impossible to trade all CDSs on
exchanges, although they are more standardized today than when they
were developed in the 1990s.
Because of these inflexible regulatory requirements, CDS
products were structured and markets developed to avoid existing
regulatory categories. Overly strict regulation backfired by
forcing CDS market participants wholly outside of the regulatory
system. Rather than attempting to force CDSs and other innovative
products into the 1930s-style regulatory straightjacket,
policymakers should adapt regulatory schemes to market
The Changing CDS Market
The CDS market is changing in two fundamental ways:
Clearinghouses will begin clearing many CDS trades, and CDS dealers
have agreed on a series of changes in how CDS are priced, traded,
and resolved after credit events that trigger payments.
Central Clearing. Under the aegis of the Federal Reserve
Bank of New York, CDS market participants have been meeting
since 2005 to discuss improvements in the CDS market structures.
Without regulatory mandates, derivatives market participants have
moved to improve the efficiency and transparency of their markets
by such steps as electronic trading and recordkeeping, trade
netting, and centralized data collection and publication. The
Depository Trust and Clearing Corporation, an industry service
organization, has begun to release weekly reports on CDS trade
volumes and value. These intermediate steps pointed
ultimately toward a clearinghouse for CDS trades.
Regulators and market participants agree that a central
counterparty or clearinghouse for CDS transactions will address
existing market imperfections. A clearinghouse will act as
intermediary for all CDS transactions, largely eliminating
counterparty risk of a trading partner or broker being unable
to keep its side of a bargain. A clearinghouse will reduce gross
risk exposure by "netting" offsetting contracts and will make trade
settlement virtually immediate. A clearinghouse can publish prices
and trade volume, making the market more transparent, and will
provide regulators with information about participants' positions
and risk exposures. Finally, a clearinghouse will increase
liquidity by imposing capital and margin requirements on
clearinghouse members and by maintaining its own capital
In short, a clearinghouse will make the CDS market more
transparent, more liquid, and less risky.
One of the major barriers to establishing a CDS clearinghouse
was the balkanized U.S. regulatory framework. While the Commodity
Futures Modernization Act allows any one of three agencies to
approve a derivatives clearinghouse, the SEC's insistence that
it should retain authority over clearinghouses approved by
other agencies and disparate regulatory standards and aims slowed
and frustrated efforts to establish one or more clearinghouses.
Following the market crisis, the regulatory agencies worked
together. In November 2008, they announced a memorandum of
understanding in which the Federal Reserve, Commodity Futures
Trading Commission (CFTC), and SEC agreed to cooperate, share
information, and harmonize regulatory requirements for a
clearinghouse for credit derivatives. Final regulatory approvals
took several additional months, but one European and two American
clearinghouses have been approved to clear CDS trades. On March 9,
ICE Trust, operating under regulation of the New York Federal
Reserve Bank, began clearing some CDS trades. ICE is beginning
with widely traded and highly standard CDS indexes and will later
expand to other types of CDSs.
The fact that market participants have been cooperating to
improve operations for several years while regulators are only now
collaborating to improve the regulatory process is an important
reminder that the private sector is often more willing and
able to reform in the face of financial challenges than
Regrettably, Congress is even further behind the curve than
regulatory agencies are. The House Agriculture Committee
recently approved legislation that would mandate CFTC regulation
and strip the Federal Reserve of authority to regulate CDS
clearing. Yet major CDS dealers are banks, which is
a powerful argument that Fed regulation is appropriate.
Even if CFTC regulation were a good idea in the abstract, an
abrupt shift in the regulatory framework would pull the plug
on a four-year cooperative public and private-sector effort to
improve CDS markets. Disrupting a government-encouraged
private-sector effort at the very moment that it is
beginning to bear fruit would be disastrous both economically
and from a public policy perspective. Markets would suffer, and it
would not likely improve the regulatory outcome.
The Obama Administration apparently plans to propose requiring
central clearing for standardized derivatives contracts. The market
has matured to a point where such a requirement for many types of
CDSs is at least feasible, even if not necessary.
However, any regulatory structure needs to be flexible enough to
allow continuing innovation and experimentation. Prior to recent
market revisions, few CDSs would have been easily cleared. New
products should be given an opportunity to develop fully before
clearing or similar requirements are imposed. Exchange trading,
which the Administration plans to "encourage," is not
practical in the near term because the CDS market lacks sufficient
volume to support anonymous auction trading.
Trading Conventions and the "Big Bang." Beginning on
April 8, CDS trades fell under new rules that affect pricing,
trading dates, and the determination and settlement of payment
obligations. The International Swaps and Derivatives
Association, a trade association of credit derivatives market
participants, functions in some respects as a private-sector
regulator of CDS markets. ISDA definitions and standard agreements
provide the basis for individual CDS trades. The ISDA changes are
so significant that they are referred to in the industry as the
CDS prices will now be calculated through a combination of an
initial "up-front" payment and a standard "coupon" (the periodic
premium) of either 1 percent or 5 percent per year depending on
creditworthiness. This will make CDS pricing more
consistent and transparent, facilitating better price
discovery and readier comparisons to related financial
products. Trades will have standard quarterly expiration dates.
Until now, parties to swaps sometimes disagreed about whether or
not a credit event triggering a payment obligation had
occurred. Disputes about credit events must now be
submitted within limited time periods to "determinations
committees" assembled by the ISDA. Creation of a regular and
objective mechanism for settling disputes should reduce the
uncertainties and, therefore, the costs associated with CDS
Finally, the new trading conventions specify that the normal
method for settling CDS obligations after a bankruptcy or missed
payment will be to auction the bonds or other debt at issue.
Previously, auctions have frequently been used for this purpose on
a voluntary basis. Making auctions standard should make settlement
more predictable and pricing more equitable.
These new trading conventions have been developed by market
participants after years of trial and experience. They will make
CDS contracts easier to clear and the market more transparent and
efficient. Continuing standardization could even lead to exchange
trading for some categories of CDSs.
However, regulators were unlikely to develop these conventions,
which required years of market development and experimentation by
the market participants. As policymakers consider whether
further regulation of CDS markets is needed, they should keep
in mind that market mechanisms and responses are often the best
solutions, even to ostensibly regulatory problems.
What Policymakers Should Do
Policymakers have focused excessively on alleged market excesses
as the cause of the financial crisis and on increased regulation as
the appropriate solution. While market excesses clearly played a
role, developments in credit derivatives markets are a reminder
that overly complex, inflexible, and outdated government
regulations contributed to market dysfunction.
The most productive regulatory reforms may not be new or
increased regulation, but rationalization of regulatory schemes to
address modern market needs and practices. Specifically:
1. Policymakers should encourage
market reforms to market problems.
The private sector has taken substantial steps to address
weaknesses in credit derivatives markets. Regulators are taking
productive steps to encourage and facilitate that reform. Further
regulatory reforms should focus on improving market structures
and incentives rather than on increasing government
intervention and control of markets.
Rather than simply assuming that more regulation is needed or
seeking a comprehensive regulatory system for ideological or
theoretical reasons, advocates of additional regulation should
be required to identify specific market deficiencies and craft
targeted responses rather than blanket mandates.
Using the New York Fed's credit derivatives effort as an
example, regulators should consider cooperative discussions
with market participants prior to coercive market intervention. In
the case of credit derivatives, regulators and market participants
largely agreed about the existence and nature of market defects.
Market participants were able to develop innovative solutions and
implement them more quickly than regulators were.
2. Policymakers should consider how
existing regulation contributed to market deficiencies.
Recent improvements in the derivatives market are a reminder
that regulatory balkanization and overlap contributed to market
imperfections. For instance, many reform proposals would create new
regulatory agencies to address the safety of particular
financial products or to promote overall market stability. Before
Congress creates a "super financial regulator" or a safety board,
it should review the jurisdictions and purposes of existing
regulatory agencies to ensure that the government is
contributing to, not hindering, productive reforms of the
Congress has already ordered a review of regulation of
over-the-counter credit derivatives in the Emergency Economic
Stabilization Act. This review and any subsequent congressional
action should focus as much on rationalizing existing regulatory
jurisdiction as on imposing new requirements on credit derivatives
markets. Simply creating new regulatory agencies on top of
existing bodies would make matters worse.
3. Rules should be flexible to allow
for and react to changes in markets.
Policymakers should keep in mind that markets evolve. Markets
cannot be created by government fiat, and they are distorted by
government intervention. Where regulation is necessary, it
should be flexible enough to allow continued market evolution
and to respond to that evolution in appropriate ways. Sound
regulation interacts with markets rather than insisting that
markets conform to preconceived government categories and
While central clearing for many CDS contracts is now feasible,
regulations should remain sufficiently flexible to allow new
or revised credit products to trade and develop in non-cleared
markets. Over time, successful products will develop
sufficient volume and standardization to permit clearing
or exchange trading. However, imposing such requirements on new
products when they are initiated would prevent useful
experimentation and market evolution.
Those who would disrupt derivatives market improvements by
mandating a change in regulatory jurisdiction should be required to
meet the high burden of proof that the regulatory disruption is
both necessary and likely to improve current arrangements. The
House Agriculture Committee's proposal to restrict derivative
clearing to CFTC-regulated clearinghouses fails both prongs of
CDSs and derivatives more generally play an important and
productive role in the economy. While the CDS market was imperfect,
arguments for draconian regulation are poorly supported and
CDS market participants have recently taken significant
steps to improve the market. Government should encourage continued
market improvements rather than reflexively impose new regulation.
If regulatory changes are made, policymakers should seek to improve
the regulatory structure rather than simply creating new agencies
or rules on top of an already complex regulatory scheme.
David M. Mason is a Senior Visiting
Fellow in the Thomas A. Roe Institute for Economic Policy Studies
at The Heritage Foundation.