Credit Default Swap Regulation

Introduction

CDS = A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default. In the pre-crises period, in 2007, the total notional amount of CDS accounted for over 60 trillion USD.

Our goal is to introduce the idea that more transparency and standardization is needed in the CDS market. This can be achieved by shifting the trading of CDS from OTC market to centralized clearing facilities.

Regulation of CDS

CDS are currently not regulated as insurance, securities or futures in the United States. CDS are, however, subject to the anti-fraud and anti-manipulation. CDS are generally privately negotiated and traded financial contracts. ISDA (International Swaps and Derivatives Association), which represents participants in the derivatives industry, has worked with its members, including the major CDS dealers, and the Federal Reserve over recent years to improve upon various shortcomings in the existing trading infrastructure and has standardized components of CDS trading documentation.

Current mechanism

1. Protection buyer and protection seller agree on the reference asset and the credit event (bankruptcy, cross-default, debt-restructuring etc.)
2. Price is set in reference to risk-free rate plus default protection fee (paid quarterly, maturity app. 5 years)
3. In the case of credit event, protection seller makes a payment to protection buyer (principal minus recovery)

Issues while establishing CDS

• Lack of transparency in pricing and valuation
• Inconsistent minimum capital requirements - inability of regulators to set market participants exposures. Therefore, capital adequacy cannot be calculated precisely.
• Non-existent licensing and registration requirements
• No oversight of participant conduct – definition of default maybe not be clear
• A lack of standard settlement periods

As a result, some finacial institutions accumulated huge liabilities from possible defaults. They did not valuate the risk properly and faced significant obligations from the CDS contracts. In the case of AIG, this led to bankruptcy followed by a government bail-out.

Benefits of standardization of CDS

Trading on standardized exchanges have these advantages:
• Standard definitions for contract terms
• Standard settlement periods
• Transparent pricing & valuation
• Minimum capital requirements
• Licensing and registration requirements
• Participant oversight by the exchange/regulatory authority

“Limits” of regulation

Ban on “naked” trading – Some market participant have reason to hedge with CDS even though they do not hold the security related to it. Example: Foreign investors in developing countries can use CDS to hedge their exposure in physical assets (factories etc.)

Restrictions on market participants – CDS market should be available for the broad variety of investors to maintain liquidity and pricing. On the other hand, trading itself should be carried out by certified entities.


AGAINST REGULATION

About CDS

CDS serve for securing against financial insolvency of the bond issuer. CDS is basically a swap designed to transfer the credit exposure of fixed income products between parties. On CDS market there is three different usage of CDS. They are hedging, speculation and arbitrage. Especially using CDS for speculative purposes was a target of criticism and arguments for imposing regulation on CDS market. The critiques argue that market became too large without any regulation and thus there was a large increase of systemic risk in economy. According to them such a large market with credit risk could cause chain reaction of bankruptcy.

All those arguments conclude CDS market was a key factor of accelerating financial crisis started in 2007.

Arguments against regulation of CDS

Firstly we have to conclude that economy is a complex system in which information is spread through price mechanism and competition. We could experienced there was a lot of signals on CDS market showing financial problems of particular companies as AIG. But that doesn’t mean CDS market failed or was a cause of the crisis. On the contrary we could conclude system was working well and problems of those companies just emerged on CDS market, because it was really efficient in exposure of unknown information.

We can use Greek as an example. "Greek politicians accused speculators of trading naked CDS and blamed them for betting on state bankruptcy, which worsened the current situation. But according to the statement of British and German authorities, who are responsible for the supervision of financial markets, there is no convincing evidence regarding the speculators accusations." [5] We can also argue that emerging of Greek insolvency information through change of Greek CDS market price may help to start solving these issues earlier.

The purpose of CDS market is to provide place where buyers and sellers can trade possibility of default of particular subject. What does failure of CDS market mean? It is the situation when members of this market can’t use market for whatever purpose they have. But when one particular company predicted future situation and based on this prediction made a wrong decision on CDS market doesn’t mean there is market failure. In case this particular company trade a lots of contracts with wrong future prediction and than went bankrupt there is no reason why to blame the market. Market didn’t failed just this company did.

But there is another argument which we have to deal with even CDS market never failed. Lots of subjects trading CDS are just speculators with no insurable interest when not holding related bonds. Does it matter? Of course not, because we can find many reasons for buying protection against particular subject default. Even in case of pure speculation there is no reason why to regulate such behavior. On the contrary pure speculation enables sharing of knowledge and wisdom through price mechanism. As explained by Eraj Shirvani at Credit Suisse: “the CDS market, not the bond market, has been the only functioning market that has consistently allowed market participants to hedge or express a credit view” [1]

"Furthermore there was a research by Houman Shadab of the Mercatus Center, which has shown that this argument is undermined by its failure to distinguish between credit-default swaps against loan defaults, and the actual bad loans and mortgage-backed securities at the root of the crisis. Stricter regulation of credit-default swaps wasn’t going to make those subprime mortgages any less likely to go bad. To be sure, there has been a great deal of deregulation in some sectors of our economy over the last 30 years or so (to be precise since Mr. Reagan was elected) — the airlines, telecom, and trucking, just to name a few — but practically none of it has been in the financial sector or has had anything to do with the current crisis." [6]

Other argument says that you can thoroughly regulate this derivative, but once you will feel comfortable with its boundaries another new derivative will spread with nearly same function. Also if you make an official market with CDS the speculative pressure will even grow due to better information about it to ordinary people, who will see the potential of easy money as the big banks did and which got burned. Finally every contract has minimally two sides and without any demand there wouldn´t be any offer. The thing is that subjects on the market underestimated the amount of risk they were taking. You ask how was that possible? The answer is more like a fairytale: Once upon a time there was a magic formula that said it's OK, it’s alright you aren't taking any additional risk. So why we shouldn’t look first this way when it comes to regulation. And why didn’t FED warned companies that this mathematical-statistical pricing model that works just on correlations sucks?

"Which is to say, the Obama administration’s regulatory proposals rest on imaginary foundations? And while the president’s populist criticism of greedy executives and unbridled capitalism may make for good headlines, it has nothing to do with the actual problem. This was that the FDIC, the Treasury Department, and the Federal Reserve created a housing bubble by encouraging a decade of careless lending. When the federal government guarantees bank loans or assets, banks have a weaker incentive to evaluate loan applicants thoroughly, and a stronger one to engage in risky behavior. When things are good, they make high profits; in the case of a catastrophic downturn, it is the taxpayers, not the banks, who foot the bill." [6]

Conclusion

On non-regulated market there is space for competition and price mechanism. Through these we can experience knowledge of all market participants and we can also benefit from knowing some information earlier. Causes of current financial crisis were deeply inherent in monetary system and policy. After years of living in a fable of abundance we realized it is not longer possible and in a way of creative destruction we have to remedy past failures of bad monetary policy.

There is no reason for blaming CDS market that it shows us such a living is not longer possible.

Sources

[1] Mackenzie, D.W.: The Meaning of Competition in the Credit Default Swap Market. [online] www.mises.org
[2] NPR: AIG And The Trouble With 'Credit Default Swaps‚. [online] www.npr.org
[3] Wikipedia. [online] www.wikipedia.org
[4] Freerepublic [online] http://www.freerepublic.com/focus/news/2502158/posts?page=1
[5] Euractiv [online] http://www.euractiv.cz/ekonomika-a-euro/clanek/barnier-chce-zprisnit-pravidla-u-kreditnich-swapu-007308
[6] Reuters [online] http://blogs.reuters.com/felix-salmon/2009/07/04/why-insurance-commissioners-should-not-regulate-cds/

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