Eric Dickinson (Fordham University – School of Law) has posted Credit Default Swaps: So Dear to Us, So Dangerous on SSRN. Here is the abstract:
Credit-default
swaps (CDS) are a valuable financial tool that has created system-wide
benefits. At the same time, however, these derivative contracts have
also created the potential for relatively few market participants to
destabilize the entire economic system. This Paper will explore (1) how
CDS could hypothetically create systemic risk, (2) how CDS have
recently exacerbated the current financial crisis, and (3) how the U.S.
legislature could best regulate CDS to minimize systemic risk in the
future.
In theory, CDS could foster systemic crisis by means
of (1) encouraging the growth of dangerous asset bubbles, (2) causing
the collapse or failure of an institution that is systemically
significant, and (3) creating perverse incentives that subvert policies
underpinning business law on a system-wide scale. This Paper will
question whether CDS helped support the growth of the sub-prime
mortgaged-backed securities asset bubble that has been blamed for
igniting the current financial crisis. Ultimately, there is evidence
cutting both ways, thereby encouraging further research into the issue.
The second of these theoretical risks has certainly come into
realization within the last few months when the trillion-dollar
company, AIG, destroyed itself by blundering in the CDS market and
causing system-wide instability. As for the third theoretical risk,
there is currently no empirical evidence that CDS has created perverse
incentives on a system- wide scale.
How should the
government regulate CDS to minimize systemic risk? After examining
seven distinct proposals, this Paper recommends that legislators
require CDS market participants to (1) maintain increased capital
reserve requirements when involved in the purchase or sale of CDS tied
to highly speculative debt; and (2) confidentially disclose their CDS
positions to the Federal Reserve. Increasing the capital reserve
requirements for companies that trade in junk-grade CDS is essential
for two reasons. First, higher capital reserve requirements protect the
solvency of systemically significant institutions that attempt to
profit from the riskiest CDS. Second, specifically targeting CDS that
are associated with the junk lending business will discourage banks
from extending cheap credit to unworthy borrowers, thereby reducing the
potential for markets to generate precarious asset bubbles. As a second
regulatory measure, confidential disclosure of CDS positions to the
Federal Reserve is an efficient but relatively non- intrusive way to
greatly facilitate the monitoring of systemic risk going forward.
While
the proposed legislative action would invariably impose costs on both
market participants and society in general, the benefits of enhanced
economic stability are incalculable.