Credit Default Swaps So Dear to Us, So Dangerous

7/31/2019 Credit Default Swaps So Dear to Us, So Dangerous

1/28Electronic copy available at: http://ssrn.com/abstract=1315535Electronic copy available at: http://ssrn.com/abstract=1315535

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Credit Default Swaps:

So Dear To Us, So Dangerous

Eric Dickinson([email protected])

Fordham Law School

Professor Alan Rechtschaffen

Derivatives and Risk Management

November 20, 2008



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Paper Abstract

Credit-default swaps (CDS) area valuable financial tool that has createdsystem-wide benefits. At the same time, however, these derivative contracts have alsocreated the potential for relatively few market participants to destabilize the entire

economic system. This Paper will explore (1) how CDS could hypothetically createsystemic 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 thegrowth of dangerous asset bubbles, (2) causing the collapse or failure of an institutionthat is systemically significant, and (3) creating perverse incentives that subvert policiesunderpinning business law on a system-wide scale. This Paper will question whetherCDS helped support the growth of the sub-prime mortgaged-backed securities assetbubble that has been blamed for igniting the current financial crisis. Ultimately, there isevidence cutting both ways, thereby encouraging further research into the issue. The

second of these theoretical risks has certainly come into realization within the last fewmonths when the trillion-dollar company, AIG, destroyed itself by blundering in the CDSmarket and causing system-wide instability. As for the third theoretical risk, there iscurrently no empirical evidence that CDS has created perverse incentives on a system-wide scale.

How should the government regulate CDS to minimize systemic risk? Afterexamining seven distinct proposals, this Paper recommends that legislators require CDSmarket participants to (1) maintain increased capital reserve requirements when involvedin the purchase or sale of CDS tied to highly speculative debt; and (2) confidentiallydisclose 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 significantinstitutions that attempt to profit from the riskiest CDS. Second, specifically targetingCDS that are associated with the junk lending business will discourage banks fromextending cheap credit to unworthy borrowers, thereby reducing the potential for marketsto generate precarious asset bubbles. As a second regulatory measure, confidentialdisclosure 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 bothmarket participants and society in general, the benefits of enhanced economic stabilityare incalculable.

This Paper Abstract replicates Part IV: Conclusion, infra.



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Introduction

By design, this [credit default swap] market, presumed to involve dealing amongsophisticated professionals, has been largely exempt from government regulation []But regulation is not only unnecessary in these markets, it is potentially damaging,

because regulation presupposes disclosure and forced disclosure of proprietaryinformation can undercut innovations in financial markets just as it would in real estatemarkets.

- Federal Reserve Chairman Alan Greenspan, September 20021

Credit default swaps, I think, have serious problems associated with them.- (Former) Federal Reserve Chairman Alan Greenspan, October

20082

This morning, on November 20, 2008, the Dow Jones Industrial Average is down43.5% from its all time high just over a year ago.3 Financial stocks are down 65.8% and

unemployment is at a 16-year high.

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U.S. Consumer prices have registered their largestone-month decline since before World War II, provoking fears of impending economicdeflation.5 Meanwhile, the public is vigorously debating whether, and to what extent,unregulated credit default swaps (CDS)6 are responsible this financial crisis. As areflection of this debate, the Google News service has accumulated over 4,370 onlinenews articles about CDS written this year,7 U.S. Congress has held numerous hearings onthe subject, and academia has busily created an outpouring of CDS-related legal theory.This Paper attempts to synthesize and develop the crucial arguments and facts relevant tothe CDS debate in the course of answering three questions:

1 Speech by Alan Greenspan,Regulation, Innovation, and Wealth Creation, FederalReserve Website, Sept. 25, 2002, available athttp://www.federalreserve.gov/boardocs/speeches/2002/200209252/default.htm2 Alistair Barr, Greenspan Sees Serious Problems with CDS, Marketwatch.com, Oct.23, 2008, available athttp://www.marketwatch.com (enter search keywords GreenspanTestimony Credit Default Swaps, then follow first result).3See, e.g., Serena Ng et al, Stocks, Bonds Tumble to New Crisis Lows, WALL ST.J., Nov.20, 2008.4See Christopher S. Rugaber,New Jobless Claims Hit 16 Year High,Newsday.com,Nov. 20, 2008, available athttp://www.newsday.com/business/ny-bzjobless1121,0,2107423.story.5See Jon Hilsenrath,Prices Post Rare Fall; A New Test For The Fed, WALL ST.J., Nov20, 2008.6 As will be discussed in greater detail throughout this Paper, CDS are financial contractsthat require one party to pay another in the event that a third party cannot pay itsobligations. Throughout this paper, CDS will refer to credit default swaps in both thesingular and plural form.7 http://news.google.com (enter search terms credit default swaps, then sort by Pastyear).


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1. Why do CDS create systemic risk to the economy?2. What role have CDS played in the current financial crisis?3. How should CDS be regulated, if at all?

In short, the answer to these questions can be summarized as follows: Although

CDS are a valuable tool that has traditionally helped businesses efficiently allocate risk,they do create systemic danger in several ways, some of which have become manifest inthe past year. As a result, CDS have intensified the scope of the financial crisis. In hopesof minimizing further systemic collapse, this Paper recommends that CDS becomeregulated in a way that balances the efficiency of a free market with the goal of economicstability. To this end, legislators should require that CDS market participants (1)maintain increased capital reserves when involved in the purchase or sale of CDS tied tohighly speculative debt; and (2) confidentially disclose their CDS positions to the Boardof Governors of the Federal Reserve System (the Federal Reserve).

I. Why Do CDS Create Systemic Risk To The Economy?

A. Summary

This section provides an overview of CDS and the CDS marketplace, and thenexamines theoretical bases for CDS-induced systemic risk. Because CDS have thepotential to allow relatively small groups of market participants to make bets that canaffect the entire economic system, they create systemic risk in approximately three ways:(1) CDS could help to create asset bubbles that threaten the health of the economy; (2)CDS could cause the failure of an institution or market that is too big or toointerconnected to let fail; and (3) the debt decoupling attribute of CDS could subvertpolicies underpinning American business law to such a degree that the entire financialsystem is at risk.

B. Definition and Overview of Systemic Risk

Systemic risk refers to the possibility of a sudden, often unexpected, event orseries of events that disrupts financial markets, and thereby the efficient channeling ofresources, to such a great degree that it causes a significant loss to, or collapse of, the realeconomy as a whole.8 Systemic collapse is distinct from regular financial loss or marketvolatility in that it affects most, if not all, people and market place participants.According to this working definition, systemic risk cannot be diversified away throughfinancial markets.

Historically, U.S. legislators have found a strong public interest in regulatingsystemic risk. For example, Congress enacted the Federal Deposit Insurance Act to helpmaintain confidence in the banking system and prevent the bank panics that plagued the

8 Robert E. Litan et al., AMERICAN FINANCE FOR THE 21STCENTURY, 98 (1997), as printedin Richard S. Carnell et al., THE LAW OF BANKING AND FINANCIAL INSTITUTIONS, 732 (4thed. 2009); see also Steven L. Schwarcz, Systemic Risk, 97 Geo L. J. 193, 204 (2008).


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U.S. during the early 1930s.9 Another example would be the federal securities laws of1933 and 1934, where Congress determined that public disclosure relevant to the pricingof widely traded securities would keep financial markets operating efficiently enough toprevent adverse and destabilizing impacts on the real economy.10 More recently,Congress created the Troubled Asset Relief Program (TARP) to help mitigate the

systemic problems present in the current financial crisis.

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In general, there are twoprimary rationales for regulating systemic risk: (1) maximizing economic efficiency;12and (2) protecting health and safety, given that the failure of a financial system couldgenerate social costs such as poverty and crime.13

C. Overview of CDS and Their Uses

CDS are contracts that require one party to pay another in the event that a thirdparty cannot pay its obligations.14 The mechanics of CDS contracts are often likened toinsurance policies:

[T]he CDS buyer is buying protection and the CDS seller is selling protectionagainst a default or other credit event with respect to the underlying debtobligations [(the debt of a reference entity)]. The buyer pays the seller apremium for this protection, and the seller only pays the buyer if there is a defaultor other credit event that triggers the CDS contract. The premium [the] cost ofprotection for the buyerincreases as the risk associated with the underlyingobligation increases. In other words, as the creditworthiness of the underlyingentity goes down, the cost of protection goes up. 15

CDS serve multiple uses. The following illustration describes how CDS canoperate as a risk-hedging device, in a way similar to insurance: A bank issues a multi-

9See Carnell (2009), supra note 8, at 732.10See Schwarcz (2008), supra note 8, at 205,06.11See, e.g., David Enrich et al.,Banks Promise to Use Rescue Funds for New Loans,WALL ST.J., Oct. 31, 2008.12 See Schwarcz (2008), supra note 8, at FN 57, citingGillian K. Hadfield,PrivatizingCommercial Law: Lessons from the Middle and the Digital Ages, 58 (Stanford LawSchool, John M. Olin Program on Law and Econ., Working Paper No. 195, 2000)available athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=220252 (The publicvalue at stake in relationships between commercial entities [] is economicefficiency.).13See Schwarcz (2008), supra note 8, at 207.14 Robert Pickel, Statement to the House Agricultural Committee, To Review The Role ofCredit Derivatives in the U.S. Economy, Hearing, Oct. 15, 2008, available athttp://agriculture.house.gov/hearings/statements.html.15 Erik Sirri, Statement to the House Agricultural Committee, To Review The Role ofCredit Derivatives in the U.S. Economy, Hearing, Oct. 15, 2008, available athttp://agriculture.house.gov/hearings/statements.html.


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billion dollar loan to a major company, General Mopeds, to be repaid in five years. Thebank becomes concerned that General Mopeds will default on the loan, so negotiates thepurchase of a CDS from a hedge fund. The terms of the CDS agreement provide that thebank will make small, semi-annual payments to the hedge fund. In turn, the hedge fundwill pay the bank the full amount of the loan to General Mopeds if there is default on that

loan. The term of the CDS agreement lasts until the loan agreement terminates.

Legal scholars have recently argued that if many lenders limit their exposure toparticular borrowers in this way, system-wide benefits will result.16 Alan Greenspanopined that because lenders to Enron and WorldCom had hedged their risk through CDS,the corporate scandals did not cause a wave of banking failures.17 Another benefit ofCDS is that because they enable banks to lend with lower risk, liquidity in the bankingindustry increases.18 That is to say, banks are willing to lend more money to morebusinesses, thereby expanding businesses access to capital. But not only banks can useCDS as hedges. A ship building business for example, can purchase a CDS referenced tocustomers (more specifically, customers debt) that the business is particularly reliant on.

Should one or more of these customers could go bankrupt, the business will be partiallyprotected from the consequential losses.

CDS can also be used as a tool for investment or speculation. A CDS buyer couldprofit by betting a particular company will fail, and a CDS seller, like a bondholder,could profit by betting that a company will not default on its debt. CDS sellers gain theequivalent of a debt interest in a company without actually owning any debt instrument. 19In other words, the payment streams from CDS buyer are the equivalent of interestpayments to a bondholder. And, like a bondholder, the CDS seller runs the risk that theissuer of the underlying debt obligation will default.

D. The CDS Market

As of this writing, CDS agreements are privately negotiated, and executedbilaterally in the over-the-counter (OTC)20 market. CDS are not currently traded on an

16 Frank Partnoy et al., The Promise and Perils of Credit Derivatives, 75 U.CIN.L.REV.1019, 1024 (2007).17 Alan Greespan, Chairman Fed. Reserve, Remarks Before the Council on ForeignRelations, Nov. 19, 2002, available athttp://www.federalreserve.gov/boarddocs/speeches/2002/20021119/default.htm.18See Partnoy (2008), supra note 16 at 1024.19See Henry T.C. Hu, et al.,Equity and Debt Decoupling and Empty Voting II:Importance and Extensions 72 (U. of Texas of Law Sch., Law and Econ Working PaperNo. 122, 2008), available athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=10307221 [hereinafter Hu II].20See, e.g., Overview and History of the OTCBB, OTC Bulletin Board Website, availableathttp://www.otcbb.com/aboutotcbb/overview.stm.


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exchange, and are not regulated by any U.S. governmental authority.21 All parties to CDStransactions are sophisticated institutions. These participants primarily include globallyactive banks, financial holding companies, hedge funds, registered investmentcompanies, as well as large insurance companies. In the last few years, ten counterparties,most of which are banks, represented at least 80% of total CDS trading.22 Of those ten

counterparties, together JP Morgan, Morgan Stanley, Deutsche Bank, and GoldmanSachs represent at least half of CDS trading volume.23 London and New York are at thecenter of CDS trading.24 Small, independent brokerages bring together counterparties tomost CDS transactions.25

The standard practice according to most CDS agreements is that CDScounterparties must adjust collateral on a daily basis as the value of the agreementchanges (as the reference entity becomes more or less likely to default). 26 This practicehelps to eliminate counterparty risk.27 For example, if a CDS contract rises in valuebecause the reference entity becomes more likely to default, the CDS seller must provideincreasing amounts of collateral, often U.S. Treasury securities or cash. If the contract

then declines in value, collateral is returned to the CDS seller. This practice of mark tomarket settlement on a daily basis mitigates a single, large, end game payment as adefault event draws near. Standard practice also indicates that counterparties postadditional amounts of collateral as their own financial condition deteriorates.28 Forinstance, a company that has received a Triple-A rating by a national ratings agencywill post less collateral than a Triple-B rated company. However, pursuant to the CDSagreement, if that same Triple-A rated company is downgraded, it is often required topost extra collateral.

Beyond counterparty risk and market risk (the risk that the CDS contract willincrease or decrease in value), market participants deal with at least two other non-systemic risks: (1) legal risk; (2) assignment risk. Legal risk is the possibility thatcounterparties will find themselves in a legal dispute. Though current statistics on legal

21 However, several groups are in the process of establishing CDS exchanges. SeeSection III.B, infra.22See, e.g.,Noah L. Wynkoop, The Unregulables: The Perilous Confluence of HedgeFunds and Credit Derivatives, 76 FORDHAM L.REV. 3095, 3105 (2008); Serena Ng et al.,CDS Data Show Scope of Wagers on Nations, WALL ST.J., Nov. 20, 2008.23See Wynkoop (2008), supra note 22, at FN 92, citingTim Weithners, CreditDerivatives, Macro Risks, and Systemic Risks, FED.RES.BANK OF ATLANTA ECON.REV.,Fourth Quarter 2007, at 43, 64.24See Sirri (2008), supra at note 15.25See Liz Rappaport, Spotlight Shines on Swap Brokers, WALL ST.J., Nov. 13, 2008.26See Felix Salmon, Why the CDS Market Didnt Fail, Portfolio.com, Oct. 19, 2008,available at, http://www.portfolio.com (search for why the cds market didnt fail,follow first result).27 Counterparty risk refers to the risk that counterparties will be unable to make paymentunder the terms of the CDS agreement.28See Pickels (2008), supra at note 14.


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risk are difficult to obtain, in 2004 approximately 14% of credit events involved a legaldispute between CDS counterparties.29 This risk has hopefully decreased in the last fewyears, however, as CDS parties have gained experience and documentation became morestandardized.30 Assignment risk refers to the danger that a counterparty will assign aCDS transaction without consent of the other party. Although most CDS agreements

require counterparty consent prior to assignment, the practice of no-consent assignmentshas grown to approximately 40% of CDS trade volume.31 Such conduct leads touncertainty as to the identity of counterparties, undermining the original parties marketand counterparty risk assessments.32

The current size of the CDS market is difficult to calculate, given that trading isdone OTC. However, in mid-September, the International Swaps and DerivativesAssociation (ISDA)33 reported that the current gross notional value of all CDScontracts is approximately $54.6 trillion.34 This value greatly exaggerates the amount ofmoney that would need to be paid out should every CDS reference entity default, becausethe overwhelming majority of CDS sellers offset their risk by purchasing a

substantially similar CDS from another CDS seller.

The following example illustrates offsetting: Alpha purchases a CDS (ReferenceEntity X) from Beta for $100, where the agreement provides that Alpha will receive $1million from Beta if X defaults. The next day, the value of the CDS drops to $99. Betathen purchases a CDS (Reference Entity X) from Delta for $99, where the agreementprovides that Beta will receive $1 million from Delta if X defaults. As a result of thesetwo transactions, assuming X does not default Beta will earn $1 in profit, Delta will earn$99 in profit, and the gross notional value of the two transactions combined is $2 million.

$100 $99

$1 million (if X defaults) $1 million (if X defaults)

Figure 1: Alpha Hedges with Beta; Beta Offsets Risk with Delta

29 Zdenka S. Griswold et al., Counterparty Risk Management Policy Group II: OTCDocumentation Practices in a Changing Risk Environment, ALI Broker DealerRegulation 187 (2006).30See Partnoy (2007), supra note 16, at 1026.31 Griswold (2006), supra note 29, at 188.32 Some legal commentators might even take the position that widespread assignmentswithout consent could cause systemic risk.33 ISDA is the largest global financial trade association, with 850 member firms.Chartered in 1985, its role is to promulgate standardized OTC derivatives documentationand lobby on behalf of its member firms, which include all major institutions thatparticipate in the OTC derivatives markets See Pickels (2008), supra note 14.34ISDA Mid-Year 2008 Market Survey Shows Credit Derivatives at $54.6 Trillion, ISDANews Release, Sept. 24, 2008.

Al ha DeltaBeta


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However, the net notional value of the two transaction is still only $1 million,because according to the practice of netting, if X defaults, Delta will just give Alphathe $1 million that it would be required to give to Beta (who would in turn have to giveAlpha $1 million). The general idea of netting is to eliminate unnecessary transactions. 35

$1 million

Figure 2: If X Defaults, Alpha, Beta and Delta Will Net the Two Transactions

The following table presents the top 25 reference entities by net notional value (asof Nov. 14, 2008):

Reference Entity Gross Notional (USD) Net Notional (USD) Contracts

1 REPUBLIC OF ITALY 151,640,355,977 17,033,411,245 3,355

2 KINGDOM OF SPAIN 63,690,626,218 14,103,459,173 1,975

3 GENERAL ELECTRIC CAPITAL CORPORATION 87,508,812,002 11,809,245,999 8,959

4 FEDERATIVE REPUBLIC OF BRAZIL 149,362,956,266 11,358,811,789 11,851

5 FEDERAL REPUBLIC OF GERMANY 37,735,584,839 9,854,708,920 738

6 DEUTSCHE BANK AKTIENGESELLSCHAFT 68,481,187,868 8,748,365,784 5,885

7 RUSSIAN FEDERATION 111,979,517,282 7,678,846,427 7,898

8 HELLENIC REPUBLIC 35,601,996,464 7,557,555,369 1,118

9 MORGAN STANLEY 93,273,636,461 7,188,002,666 10,067

10 THE GOLDMAN SACHS GROUP, INC. 94,039,544,028 6,500,381,025 9,895

11 REPUBLIC OF TURKEY 190,812,225,523 6,310,120,101 14,285

12 MERRILL LYNCH & CO., INC. 95,031,516,396 6,262,327,065 10,015

13FRENCH REPUBLIC 21,649,394,270 5,906,755,480 51514 REPUBLIC OF KOREA 51,553,104,051 5,383,948,996 4,636

15 COUNTRYWIDE HOME LOANS, INC. 84,992,389,586 5,221,086,007 11,938

16 REPUBLIC OF AUSTRIA 16,412,127,895 5,203,043,051 600

17 BARCLAYS BANK PLC 44,552,698,284 5,084,065,164 4,263

18 REPUBLIC OF PORTUGAL 24,526,177,517 4,885,595,283 774

19 SLM CORPORATION 49,084,672,672 4,739,446,163 7,935

20 CITIGROUP INC. 66,637,537,330 4,731,325,037 6,502

21 BERKSHIRE HATHAWAY INC. 18,491,414,194 4,722,693,035 2,450

22 UBS AG 30,997,897,750 4,704,229,570 2,915

23 DEUTSCHE TELEKOM AG 67,930,286,934 4,660,998,294 6,885

24 MBIA INSURANCE CORPORATION 53,274,505,998 4,634,987,364 5,95725 IRELAND 17,295,994,579 4,600,476,623 628

35See, e.g,. Charles Davi,Netting Demystified, Derivative Dribble Blog, available athttp://derivativedribble.wordpress.com/2008/10/24/netting-demystified.

Alpha Delta


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Figure 3: Top 25 CDS Reference Entities by Net Notional Value of Potential Default

Payouts36

As Figure 3 illustrates, the gross notional value for most of these reference entitiesis much, much greater than the net notional value. This data therefore indicates that

many sellers of CDS will also purchase CDS on the same reference entity to offset theirrisks. Following the pattern of relative gross notional vs. net notional values for theabove referenced entities, one can make an educated guess that the net notional value ofall outstanding CDS contracts (gross notional at $54.6 trillion) lies somewhere between$3 trillion and $15 trillion.

E. How CDS Create Systemic Risk

As mentioned earlier, CDS have the potential to create systemic risk in threeways. While each type of systemic risk is distinct from the others, the common threatunderlying all is that CDS enables relatively few market participants to endanger the

system. Perhaps certain groups of participants may have the appetite for risky bets, butshould these bets fail, the entire financial system bears the consequences.

1. CDS Could Help To Create Asset Bubbles That Threaten The Health Of The

Economy.

Part I.C. of this Paper (above) describes how CDS enable banks to lend at lowerrisk. Banks can purchase CDS to effectively ensure that they will receive full value forthe loan extended. Because of this insurance, a bank no longer needs to be concernedabout the risk of borrower default just as long as the bank is able to find counterpartieswilling to sell CDS referenced to the loan. As a result, banks have incentive to extend asmuch credit to default-prone borrowers37 as legally possible.38 According to economictheory, such behavior can lead to the creation of dangerous asset bubbles.

An asset bubble is a situation where an assets price exceeds the fundamentalvalue of the asset.39 Fundamental value is defined as the expected value of all dividendsthat the asset will yield over its lifetime, discounted for present value.40 A traditional

36DTCC Deriv/SERV Trade Information Warehouse Reports, DTCC Website, availableathttp://www.dtcc.com/products/deriserv/data/index.php.37 Default-prone borrowers will pay higher interest rates than investment gradeborrowers, further enriching banks.38 Depending on where the bank obtained its charter, it must maintain a certain capitalreserve ratio and total risk-based capital ratios, among other requirements. See generally,Carnell (2009), supra note 8.39 Gadi Barlevy,Economic Theory and Asset Bubbles, 31 ECON.PERSPECTIVES 1, 46(2007).40Id.


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explanation for the cause of asset bubbles is expansionary monetary policy.41 In such ascenario, fractional reserve banks lower interest rates and provide increasing monetaryliquidity. When interest rates go down, investors will leverage their capital by cheaplyborrowing from banks and investing leveraged capital in assets such as real estate andequities. The effect of this behavior on a large scale is too much money chasing too few

assets, causing the assets to appreciate to an unsustainable level, i.e., beyond theirfundamental value. Inevitably, the central bank will raise interest rates, increasing thecost of borrowed capital. Investors will then stop purchasing assets at such a high price,the holders of the assets will start selling (realizing there are no more buyers), and theassets will plummet in value. History has repeatedly shown that the bursting of assetbubbles, if large enough, can collapse entire financial systems.42

This Paper posits that CDS have the same causal effect on asset bubbles as anexpansionary monetary policy. As CDS decrease the lending standards of banks, bankswill lend more freely to unworthy junk borrowers, and at lower interest rates (tocompete effectively against other banks). Once interest rates go down, junk borrowerswill use cheap credit to purchase assets. As cheap credit persists, the assets eventuallybecome overvalued and a bubble is created. Furthermore, if investors use cheap credit tosell CDS to banks, the effect is magnified to an even greater degree because banks willthen lower interest rates even further (or at least increasing lending to junk borrowers).Under these circumstances, the CDS sellers are selling premiums that are too low,creating another bubble in the CDS market. The CDS bubble will burst when CDS sellerscan no longer buy CDS to offset their own risks. The CDS market could potentially lockup and collapse as the cost of purchasing CDS becomes prohibitively high. No longerable to hedge against bad loans, such a development could then cause banks to raiseinterest rates, popping any other asset bubbles that have been created from easy credit.Also, even if there is no CDS bubble, central banks can raise interest rates that willincrease borrowing costs and in so doing burst asset bubbles.

2. CDS Could Cause The Collapse Of An Institution That Is Too Big or TooInterconnected To Let Fail.

Too big to fail is traditionally known as an expensive and unpopular U.S. policycentered on the idea that any one of the largest eleven American banks is too big let fail.43If one of these banks is teetering on collapse, the U.S. government willprobably step inand provide funds to keep the bank solvent. John LaWare, a former governor of theFederal Reserve System, describes why a large bank failure causes systemic risk:

The ramifications of that kind of failure are so broad and happen with suchlightning speed that you cannot after the fact control them. It runs the risk of

41See, e.g., Mark Buchanan, Why Economic Theory is Out of Whack, NEW SCIENTIST,July 19, 2008.42See, e.g., Litan (2008), supra note 8, at 112.43 George Kaufman, Too Big To Fail In U.S. Banking: Quo Vadis?, Working paper,January 15, 2003, available athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=386902.


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bringing down other banks, corporations, disrupting markets, bringing downinvestment banks along with it [] We are talking about the failure that coulddisrupt the whole system.44

Economists and legal scholars argue not only that the failure of large banks create

systemic risk, but also the collapse of any large firm that has extensive interlinkages withother large firms poses systemic risk. For example, Professor Dombalagian of TulaneLaw School contends that any of the largest securities firms are too interconnected tofail.45 Such firms are too interconnected to fail because they are counterparties tothousands upon thousands of transactions in numerous markets. Should a large firm failto stand behind its transactions, chaos in those financials markets could result ascounterparties attempt to unwind their transactions.46 As numerous parties attempt to selltheir positions, market liquidity disappears. The result is that solvent, but suddenlyilliquid market participants may default on their own obligations. This could lead to thefailure of even more highly interconnected firms, spreading the crisis to other areas of thesystem.

As mentioned in Part I.D., above, CDS transactions are traded almost exclusivelyin the OTC market. The OTC market is not transparent, and pricing information on CDSis not publicly available. Even according to sophisticated CDS traders, the marketremains maddeningly opaque.47 For instance, many investors, creditors, and otherbusiness counterparties could be uncertain whether a lender has hedged its position withCDS. This lack of relevant information prevents the CDS market from uncovering themost competitive market prices,48 which leads one to the inescapable conclusion that atleast some CDS are priced incorrectly when sold, or perhaps should not have been sold atall.

Because the firms that trade a vast majority of CDS volume are firms that aregenerally considered either too interconnected to fail or too big to fail (maybeboth),49 systemic risk is created when these firms price too many CDS incorrectly, andinadvertently subject themselves to unexpected risks. Said another way, if a largefinancial institution buys or sells too many CDS without properly anticipating the amount

44 LaWare, John, Testimony, Economic Implications of the Too Big to Fail Policy:Hearing Before the Subcommittee on Economic Stabilization of Committee on Banking,Finance and Urban Affairs, U.S. House of Representatives, 102nd Cong., 1st Sess., May9, 1991.45See generally Onnig H. Dombalagian, Too Interconnected to Fail?: Investment Banksand Systemic Risk, Working paper, available athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=1249441.46Id.47 Frank Partnoy et al., Credit Derivatives Play a Dangerous Game, FIN.TIMES, July 17,2006.48See generally, Eugene F. Fama,Efficient Capital Markets: A Review of Theory andEmpirical Work, 25 J.FIN. 383 (1970).49See Section I.D, supra.


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of collateral that it will ultimately need to pay its counterparties, or without properlyanticipating the risk that its counterparties would be unable to pay, the large institutioncould suddenly and unexpectedly be driven into insolvency. If the government does notstep in and save the institution, such an event will adversely affect all of itscounterparties, both in the CDS market50 and in other markets that the financial

institution deals in. As counterparties that relied on the financial institution also fold dueto lack of liquidity in the markets, the liquidity crisis spreads throughout the financialsystem. Finally, even if the government did step in to save the failing institutions,investor could lose confidence in the financial markets, which also has the effect ofdecreasing liquidity on a large scale.

3. The Debt Decoupling Attribute Of CDS Could Subvert Policies Underpinning

American Business Law To Such A Degree That The Entire Financial System Is At Risk.

Legal commentators, especially Professors Hu and Black,51 have theorized thatCDS undermine the large body of American business law related to creditor rights. For

instance, U.S. bankruptcy laws generally assume that a creditor would prefer that itsborrower to stay out of bankruptcy and continue paying interest on its loans.52 Bankinglaws assume that a bank will carefully attempt to issue loans only to borrowers that willcan repay both principal and interest, and that the bank will continue to monitor theborrower to make sure he does so.53 These assumptions are no longer valid now thatCDS have the ability to separate the economic interests of creditors (receiving payment,risk of default) from the control rights of creditors (to enforce, waive, or modify debtcontracts, as well as the right to participate in bankruptcy proceedings). Professors Huand Black describe this separation as debt decoupling.54 Debt economic and controlrights are decoupled when a creditor purchases a CDS, because while the creditormaintains control rights over the debt, the CDS seller effectively takes the economicinterest in the debt the seller receives payment (albeit from the creditor) but also bearsthe risk of default on the underlying debt.

50 Roughly ten counterparties trade over 80% of the CDS volume (see section I.D.,above). Should one of these firms fail (due to any number of reasons), the CDS market,one of the worlds largest financial markets, would perhaps crash immediately. Theparticipants in the CDS market is are some of the most interconnected in the entireeconomy. Notice in Figure 3, above, that the reference entity Goldman Sachs, to use asan example, has 9,895 outstanding CDS contracts referenced to it with a net notionalvalue of $6.5 billion, but a gross notional value $94.0 billion. This means that theaverage CDS referenced to Goldman has been offset fourteen times; therefore fourteenfirms are linked together on this chain of transactions.51See, e.g., Henry Hu & Bernard Black,Debt, Equity, and Hybrid Decoupling:Governance and Systemic Risk Implications, U. of Texas Sch. Of L., L. and Econ.Working Paper No. 120 (2008).52Id. at 16.53See Partnoy (2008), supra note 16 at 1033.54 Hu (2008), supra note 51, at 16.


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Debt decoupling can theoretically create systemic risk by (1) subjectingcontractual creditors to moral hazard, and (2) providing debtholders with a negativeeconomic interest to affirmatively destroy value. Each of these issues will be discussedin turn.

In the first instance, moral hazard is commonly defined as the tendency ofinsurance to alter the insureds behavior, or, more extensively, as the tendency tomaximize ones own utility to the detriment of others when one does not bear the fullconsequences or enjoy the full benefits of ones actions.55 Moral hazard can be appliedto a creditor who has hedged with CDS, in that the creditor has no interest in wasting itstime and resources monitoring the borrower. The creditor does not care if the borrowerdefaults, because either way the creditor will be getting paid. However, because the CDSseller has no contractual relationship with the borrower, the CDS seller cannot play therole of monitor and make sure that the borrower does not squander the loan.56 For anyone loan, this behavior is merely inefficient, and should be weighed against the benefitsof the risk-spreading function of CDS in the first place. Yet, for millions and millions of

loans, such an inflexible relationship between CDS seller and borrower creates systemicrisk.57

In the second instance, a negative economic interest is described as a creditorwhose ownership of debt is less than his ownership of CDS insuring that underlyingdebt.58 Such a creditor stands to gain by sending the issuer of said debt into default orbankruptcy, triggering a CDS payout. For example, a creditor with a negative economicinterest will almost certainly use its influence to force the company into bankruptcyrather than agree to restructuring or making concessions on the loan, regardless of socialcost. 59 In this way, creditors with a negative economic interest can profit by destroying aproductive, competitive company that may have just missed an interest payment.Similar to the moral hazard issues that debt decoupling can create, a single event is

55See Richard S. Carnell,A Partial Antidote to Perverse Incentives: The FDICImprovement Act of 1991, 12 ANN.REV. OF BANK L. 371 (1993).56Butsee Partnoy (2008), supra note 16 at 1040 (In theory, the counter-parties to acredit default swap could take up the slack, assuming the banks monitoring role alongwith their credit risk exposure.). A problem with this theory is that the borrower wouldhave to assent to the CDS seller receiving confidential information.57See Hu II (2008), supra note 19 at 788 (describing the relationship between creditors,debtors, and third party investors when debt has been securitized and sold).58 Henry Hu, Statement to the House Agricultural Committee, To Review The Role ofCredit Derivatives in the U.S. Economy, Hearing, Oct. 15, 2008, available athttp://agriculture.house.gov/hearings/statements.html.59See Hu II (2008), supra note 19 at 788. But see, U.C.C. 1-203 (1977) (every contractis subject to an obligation of good faith in its performance or enforcement); Brown v.Avemco Investment Corp., 603 F.2d 1367 (9th Cir. 1979) (holding that a lender can onlyaccelerate a loan if the acceleration would be a shield against increased risk to the lender.It cannot be used a sword to get greater gains.).


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merely inefficient. However, if creditors with negative economic interests pervade theeconomy, affirmatively destroying value, then systemic risk is a real possibility.

II. What Role Have CDS Played In The Current Financial Crisis?

A. Summary

Although the CDS market is currently functioning better than most financialmarketsin that the CDS market has maintained enough liquidity to consistently allow

market participants to hedge risk or speculateCDS have exacerbated the current

financial crisis in the following ways: (1) CDS may have indirectly promoted the sub-prime asset bubble that is widely considered responsible for the current financial crisis;

and (2) improperly priced CDS transactions directly led to the governments purchase of

a control-stake in AIG a move which obliterated billions of dollars in shareholdervalue and further destabilized the world financial system.

Other than AIG, CDS have not yet directly caused the failure of any largeinstitution. However, this Paper predicts that if CDS prices rise to such a degree thatparticipants in an illiquid market cannot offset their positions, it follows that more

institutions will fail as counter-parties demand collateral.

B. The Sub-Prime Mortgage Crisis

Between 2001 and 2006, poor underwriting standards and excessive lending led toa very large number of default-prone home mortgages.60 Billions upon billions of dollarsworth of these high-risk loans were securitized (in the form of collateralized debtobligations (CDOs)) and sold to investors, thereby freeing up the balance sheets oflenders and allowing them to continue making similar high-risk loans at relatively low(but variable) interest rates.61 Many investors of sub-prime CDOs were financialinstitutions.

Commentators still debate why investors were eager to purchase sub-prime CDOsthat were likely to default,62 however it is undisputed that many CDO investors hedgedtheir risk by purchasing CDS on the underlying debt.63

60 Yuliya Demyanyk et al., Understanding the Subprime Mortgage Crisis, Aug. 2008,Working paper, available athttp://ssrn.com/abstract=1020396.61Id.62 One theory is that investors had asymmetric information. Another theory is thatinvestors knew the investments were bad, but nevertheless were irrationally tempted bythe high-yield offered by these securitized assets. Id.63 Hank Greenberg, Statement of Maurice R. Greenberg: Before the United States Houseof Representatives Committee on Oversight and Government Reform, Oct. 7, 2008,available athttp://online.wsj.co/public/resources/documents/20081007101332.pdf; seealso Isaac Lustgarden,De Facto Regulation of Hedge Funds Through the FinancialServices Industry and Protection Against Systemic Risk Posed by Hedge Funds, 26NO.


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Meanwhile, as borrowers purchased more and more residential housing, driving

up the value of most homes beyond their fundamental value,64 an asset bubble in thehousing market was created.65 In 2007, once sub-prime borrowers began to default ontheir obligations at an accelerating rate, the housing bubble burst.66 The market value of

CDOs linked to sub-prime mortgages plummeted as well, collapsing the market for sub-prime CDOs.67 Investors, including most large financial institutions, had to write downthe value of these assets on their balance sheets to market value (which was close tozero). As a result of these write-downs, numerous large financial institutions becameinsolvent, including Bear Stearns, Freddy Mae, Fanny Mac, Lehman Brothers,Countrywide Mortgage, Merrill Lynch, and the list goes on. Systemic emergency hasensued, and to this day the crisis continues to grow.

As mentioned above, many large financial institutions purchased CDS referencedto their CDO assets, perhaps believing that CDS would hedge their exposure to sub-primeCDOs. This Paper speculates that at least some of these institutions would not have

purchased so many CDOs had they been unable to obtain CDS hedges.

68

If this theoryproves to be valid, then it logically follows that CDS helped propagate sub-primemortgage loans, their subsequent securitization, and ultimately the current financial crisis.

C. Lehman Brothers Bankruptcy

Lehman Brothers (Lehman), a giant among securities firms, with over 100years of history, declared bankruptcy this past September after writing down the assetvalues of its numerous sub-prime mortgage CDOs.69 The bankruptcy was a watershedmoment in CDS history because it was by far the largest credit event to test thefunctioning of the market. Practicing attorneys in the field of derivatives litigation

10BANKING &FIN.SERVICES POLY REP. 1, 7 (Bear Stearns has sold a large amount of[CDS] on various bonds, including those backed by sub-prime mortgages [] making abet that conditions [in the sub-prime market] will improve or will not further deteriorateas some people think.); but see Gregory Zuckerman,Paulson & Co. Scores Again ThisYear, WALL ST.J., Oct. 24, 2008 (describing how John Paulson personally profited over$3 billion, in part by speculatively purchasing CDS on the debt of financial companiesand possibly sub-prime CDOs as well.).64See Section I.E.1, supra.65See Demyanyk (2008), supra note 60, at 48.66 Larry Elliott, Credit Crisis- How It All Began, THE GUARDIAN, August 5, 2008available athttp://www.guardian.co.uk/business/2008/aug/05/northernrock.banking.67Id.68 Unfortunately, to the authors knowledge, no empirical studies have been conducted onthis specific issue.69See, Carrick Mollenkamp et al.,Lehmans Demise Triggered Cash Crunch AroundGlobe, WALL ST.J., Sept. 29, 2008.


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believed that systemic risk in the CDS market has moved from possible to probable.70Nevertheless, despite the Lehman bankruptcys paralyzing impact on scores of financialmarkets,71 two months later the CDS market appears to have emerged relativelyunscathed.72

Lehmans bankruptcy affected the CDS market on two levels. First, thebankruptcy is certainly a credit event that triggered all CDS tied to Lehmans outstandingdebt issuances. Because there had never been a CDS credit event referenced to an entitythe size of Lehmans debt, approximately $400 billion,73 practitioners were veryconcerned that one or more large institutional counter-parties would default theirresulting obligations, resulting in a domino effect.74 Nonetheless, on October 22, 2008,the DTCC75 successfully completed the automated settlement of all CDS related toLehman credit events.76 After netting, only $5.2 billion actually transferred hands.77There have been no public reports of any institution defaulting on its obligations as aresult of the settlement. Financial commentator Felix Salmon describes the settlement asthe non-event of the year.78 This is an apt expression, because standard practice in the

CDS market requires that counterparties adjust collateral on a daily basis as the contractchanges value. Therefore, as the Lehman CDS rose in value (and as Lehman approacheddefault), CDS sellers would have already paid out most of the contract value tocounterparties. Therefore the non-event of the year merely refers to margin settlementrelated to the day Lehman actually declared bankruptcy, which may not have been such asurprise to the CDS market after all.79

On a second level, Lehman had been a primary participant in the CDS market.Lehmans bankruptcy therefore created the danger it would be unable to satisfyobligations to its counterparties. Kevin LaCroix, a CDS trader, opines that Lehman was

70 Timothy W. Mungovan et al.,Problems and Opportunities in the Credit Default Swap(CDS) Market(Sept. 17, 2008), available athttp://www.nixonpeabody.com (navigate toClient Alerts on home page).71See Andrew Ross Sorkin et al., 36 Hours of Alarm and Action as Crisis Spiraled, N.Y.TIMES, Oct. 2, 2008, at A1.72See, e.g., The Meltdown That Wasnt, WALL ST.J., Nov. 15, 2008 [hereinafterMeltdown].73 Serena Ng,DTCC Issues Estimate on Lehman Swaps,WALL ST.J., Oct. __, 2008.74 Mungovan (2008), supra note 70.75 DTCC provides settlement and information service for OTC derivatives. See DTCCWebsite, available athttp://www.dtcc.com76DTCC Process Credit Event for Lehman Brothers, DTCC Website, Oct. 22, 2008,available athttp://www.dtcc.com/news/newsletters/dtcc/2008/oct/lehman_credit_event.php.77Id.78 Salmon (2008), supra note 26.79Id.


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the type of blue chip company that would not usually need to offer collateral.80 Assuch, Lehmans default could have particularly injured its CDS counterparties, butfortunately this scenario did not come to pass. Under U.S. bankruptcy law, thecounterparties to a failed firm like Lehman are able to net-out payments owing to andfrom the bankrupt counterparty without requiring approval from the bankruptcy judge.81

Furthermore, CDS counterparties may legally foreclose on collateral that the bankruptparty posted.82 These two protections help prevent counterparties from taking large non-market losses. However, it seems that a third development played the larger role inprotecting Lehmans counterpartiesBarclays September 16th acquisition of LehmanBrothers businesses and assets.83 As part of a larger deal to acquire Lehmans (1)investment banking division, (2) fixed income and equities sales division, and (3) tradingand research operations division, Barclays Bank provided Lehman with $500 million indebtor-in-possession financing, as well as a substantial interim credit facility to fundLehmans ongoing operations.84 This support has probably provided Lehman with thenecessary resources to continue operating as a stable CDS counterparty.

The Lehman Brothers bankruptcy illustrates how the CDS market continues tooperate efficiently85 in the midst of a financial crisis, even after a major marketparticipant simultaneously went bankrupt and triggered the CDS on one of the marketslargest reference entities. On the other hand, while the CDS market is still functioningtoday, if one large market participant collapses without credit support from another largeinstitution (like Barclays), systemic crisis could still potentially spread into this market.

D. AIG Destroys Itself By Selling Mis-Priced CDS

The blunders of the American International Group (AIG), the worlds largestinsurance company, offer the first-ever instance of an institution that is toointerconnected to fail acting to devastate itself, its shareholders, U.S. taxpayers, and thegreater financial system simply by the misuse of CDS. As a result, one of the mostsuccessful companies in business history,86 with over $1 trillion in assets,87 has beenalmost entirely nationalized.

80 Alan Rappeport, Systemic Risk Haunts Credit-Default Swaps, CFO.com, Sept. 18,2008, available athttp://www.cfo.com/printable/article.cfm/12280060.81See, e.g., Pickel, supra note 14.82Id.83SeeBarclays to Acquire Lehman Brothers Business and Assets, Lehman BrothersPress Release, Sept. 16, 2008, available atwww.lehman.com (navigate to News athomepage).84Id.85See Meltdown, supra note 72.86 AIGs market capitalization increased 40,000 percent between 1969 and 2004. SeeGreenberg, supra note 63.87Id.


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In 1998, a subsidiary of AIG, AIG Financial Products (AIGFP), began sellingCDS.88 From 1998-2005, while Hank Greenberg operated as CEO, the CDS businessoperated very conservatively. But upon Mr. Greenbergs retirement, the sale of CDSexploded, and between 2005 and 2007 AIGFPs netnotional exposure to sub-primemortgages reached at least $57.8 billion.89 Mr. Greenberg speculates that the reason for

this sudden exposure is that the company did not follow internal risk controls that he andhis team put in place, such as weekly meetings to review all of the companys risks andinvestments.90 The Wall Street Journal has stated that AIGs sub-prime CDS exposuresskyrocketed because AIGFPs risk models were flawed.91 Either way, by August 2008AIG had posted $16.5 billion in total collateral on CDS.92 Shortly thereafter, onSeptember 16, 2008, ratings agencies slashed AIGs credit ratings.93 That same day,pursuant to CDS contracts, counterparties demanded more collateral than AIG hadavailable. Thus, rather than declare bankruptcy, AIG sought a bailout from the U.S.government.94

AIG is a company that does business in every country in the world.95 If the U.S.

government had allowed AIG to fail, many financial economists are convinced that theeffects would be mind boggling [] They [would] take everything with it.96 Now theU.S. Treasury has a 79.9% ownership interest in AIG and stands behinds AIGsobligations to counterparties. Perhaps the too big to fail policy97 has saved the worldfrom immediate economic destruction after all. However, AIGFPs mis-priced CDS havenonetheless destroyed many investors confidence in the financial system,98 furtherdrying up liquidity in the markets and plunging the economy deeper into crisis.

E. Potential Future Implications of CDS In the Crisis

To date, a large institution has not been allowed to fail in its entirety. The U.S.government has supported AIG, and Barclays has covered most of Lehmans obligations.Healthier institutions such as JP Morgan and Bank of America have acquired the othervarious, large, failed institutions, such as Bear Stearns, Countrywide Mortgage, and manymore. Yet systemic risk remains. If a large CDS market participant completely foldswithout any third party support, the CDS market may fall apart as counterparties to the

88See Carrick Mollenkamp et al.,Behind AIGs Fall, Risk Models Failed to Pass RealWorld Test, Wall St. J., Nov. 3, 2008.89See Greenberg, supra note 63.90Id.91See Mollenkamp, supra note 88.92Id.93Id.94See, e.g., Pickel, supra note 14.95 Elizabeth Strott, Why AIG Matters, MSN Money, Sept. 16, 2008, available athttp://articles.moneycentral.msn/com/investing/dispatch/why-aig-matters.aspx.96Id.97 See section I.E., supra98See Strott, supra note 95.


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failed firm try to unwind their positions and take losses. This chaos could pull anotherlarge institution in into insolvencyespecially if it was relying on either collateral fromthe failed firm or the ability to use the CDS market to offset risk leading to a dominoeffect of CDS-induced systemic failures.

III. How Should CDS Be Regulated, If At All?

A. Summary

This section discusses regulatory approaches that could be taken to minimize

systemic risk caused by CDS. A range of proposals will be examined, including: (1) self-regulation; (2) elimination of speculative (naked) CDS trading; (3) public disclosure

of CDS trades; (4) confidential disclosure of CDS trades to a government regulator; (5)

elimination of OTC CDS trading;(6) exposure limitations on particular CDS trades; and(7) increased capital reserve requirements for market participants involved in the

purchase or sale of CDS tied to highly-speculative (junk) debt.

Upon weighing the efficiency costs against the systemic benefits of the aboveproposals, this Paper recommends that not only should the CDS market participants

continue to introduce self-regulatory mechanisms to minimize systemic risk, but also

Congress should grant the Federal Reserve authority to (A) obtain CDS tradinginformation from market participants on a confidential basis and (B) create as well as

enforce increased capital reserve requirements for market participants involved in the

purchase or sale of CDS tied to highly speculative debt.

B. Self Regulation of the CDS Market

Within the last few years, an overwhelming amount of legal scholarship hasargued that self-regulation (i.e., non-governmental regulation) of CDS and the derivativesmarkets is sufficient to curtail systemic risk, for the reason that government interventionis both pointless and wasteful.99 Professor Baird submits that our understanding ofcapital structures is simply too primitive for us to do much more than enforce thecontracts as they are written as best we can. [] Imposing [regulations] that are too rigidor too mechanical may limit the ability of investors to create capital structures that arebeyond the ken of those writing the rules.100 Moreover, even if regulators could gain acomplete understanding of the complex interplay between CDS and the rest of theeconomy, Professor Davidoff reasons that regulatory efforts would be futile because

99See, e.g., Douglas G. Baird, Other Peoples Money, 60 STAN.L.REV. 1309 (2008);Steven M. Davidoff,Paradigm Shift: Federal Securities Regulation In the NewMillennium, 2 BROOK.J.CORP.FIN.&COM.L. 339 (2008); Griswold, supra note 29;Lustgarten (2007), supra note 63; John T. Lynch, Credit Derivatives: Industry InitiativeSupplants Need For Direct Regulatory InterventionA Model For the Future of U.S.

Regulation?, 55 BUFF.L.REV.1371 (2008); Steven L. Schwarcz,Rethinking theDisclosure Paradigm In a World of Complexity, 2004 U.ILL L.REV. 1 (2004).100 Baird (2008), supra note 99, at 1015.


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creative financial professionals will simply offer substitute financial products that mimicthe prohibited or [regulated] investment.101

Following an alternative line of reasoning, some legal theorists believe that therisk management initiatives of private financial institutions are the most efficient and

effective method of diminishing systemic risk, because not only do financial institutionsunderstand the market better than any regulator, but also it is in the best interests ofindustry players to minimize risk.102 The business press has largely adopted thisrationale, praising the recent efforts of CDS counterparties that have increased theircollateral requirements, improved record keeping, and demanded approval overassignment of CDS assignments.103 In recent weeks there has been much news coverageregarding how several groups are competing to create a relatively transparent CDSexchange.104 The New York Federal Reserve has supported this specific privateinitiative, as long as the exchange includes a central counterparty (CCP) to cleartrades: [A CCP] will help reduce systemic risk associated with counterparty creditexposure and improve how the failure of a major participant would be addressed.105

While a CCP would certainly help to minimize the risk that the CDS marketwould collapse if/when a large market participant defaults on its obligations,106 othersystemic risks related to CDS are still not addressed by private initiatives. For example,when AIG failed because of mis-priced CDS sales, the impact of the failure shockednumerous financial markets. A CCP cannot always prevent that occurrence, but can onlyhelp to keep the CDS market from devastation. Also, there is no clear evidenceindicating that a majority of CDS trades will move from OTC to an exchange. OTCallows for highly customized contracts, whereas exchanges only trade standardized,fungible CDS. Unless large institutions find it more efficient to do most of their tradingon an exchange, the proposed CDS exchanges will not impact systemic risk one way orthe other. Furthermore, a CDS exchange and CCP cannot prevent the build up ofdangerous asset bubbles like the sub-prime CDO market. These measures merely

101 Davidoff (2008), supra note 99, at 345.102Seegenerally Lynch, supra note 99 .103See, e.g., Jonathan R. Laing,Defusing the Credit-Default Swap Bomb, BARRONS,Nov. 17, 2008,http://online.barrons.com/article/SB122671605643530511.html/.mod=googlenews_barrons&page=1.104See, e.g., Doug Cameron et al.,Bank Group to Start CDS Clearinghouse, WALL ST.J.,May 30, 2008; Ciara Linnane et al.,NY Federal Reserve Pushes for Central CDSCounterparty, REUTERS, Oct. 6, 2008, available athttp://www.reuters.com/articlePrint?articleId=USN0655208920081006.105 Linnane (2008), supra note 104.106See, e.g., Sirri (2008), supra note 15 (A central counterparty could further reducesystemic risk by novating trades to the CCP, meaning that Dealers X and Y no longer areexposed to each others credit risk. In addition, the CCP could reduce the risk ofcollateral flows by netting positions in similar instruments, and by netting all gains andlosses across different instruments.).


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facilitate the operation of the CDS market, but cannot discriminate which CDS tradeswould ultimately encourage a misallocation capital in other markets.

Finally, self-regulation as a general proposition cannot sufficiently curtailsystemic risk because of an incentives problem popularly known as the tragedy of the

commons.

107

According to this theoretical problem, multiple individuals actingindependently in their own self-interest can ultimately destroy a shared resource evenwhere it is clear that it is not in anyones long-term interest for this to happen. Theclassic example begins with numerous herders sharing a common parcel of land.108 It isin each herders interest to put as many cows as possible onto the land to graze, even ifthe commons is destroyed as a result. This is because the herder receives all of thebenefits from the added cows, whereas the cost of the destroyed commons is shared by allof the herders. The tragedy of the commons problem may also apply to the CDS market.A large market participant may take risky bets because it will individually receive thebenefits if the bets pay off, while everyone shares the cost of a financial collapse if thebets fail. Therefore it is in the public interest for a government regulator to compel all

participants to reduce excessive risk.

B. Elimination Of Speculative (Naked) CDS Trading

Some legal theorists and regulators have concluded that in the context of systemicrisk, CDS regulation should be viewed in a bifurcated manner: CDS trades for (1)speculative purposes and (2) hedging purposes.109 This Paper posits that regulating CDSin such a way is inefficient to the point where the costs of regulation clearly outweigh thebenefits. Hedging and speculating CDS parties are inextricably meshed in the CDSmarket. Without one, the other would be greatly injured. Hedging parties create aneconomic purpose for the existence of the market (efficient risk-spreading), whilespeculative traders offer the needed liquidity for the market to function.

A short time ago, the New York Insurance Department (NYID) proposed thatfederal regulators prohibit naked CDS (i.e., CDS entered into purely for speculativepurposes).110 NYID Superintendent Eric Dinallo noted that naked CDS do not spread andtherefore minimize risk to parties, but instead create risk.111 This conclusion is both trueand false. Systemic risk aside, CDS is a zero-sum transaction. Therefore it will alwayscreate risk for at least one of the parties. However, naked swaps create liquidity in themarket so that hedging CDS can be purchased at an efficient price. To clarify, the greatmajority of CDS are offsetting transactions. Only a small percentage of CDS involve a

107 Garrett Hardin, The Tragedy of the Commons, SCIENCE, Vol. 162, No. 3859(December 13, 1968), pp. 1243-1248; See also Schwarcz (2008), supra note 8, at 206.108See Hardin (1968), supra note 107.109See Schwarcz (2008), supra note 8, at 219, 220; Liskov,New Regulation of CreditDefault Swaps by the New York Insurance Department; New Best Practices for

Financial Guaranty Insurers, Dewey and LeBoeuf Client Alert, Sept. 15, 2008.110 Liskov, supra, note 109.111Id.


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hedging purchaser (such as a bondholder). However, the counterparty that sells the CDSto that hedged party almost inevitably offsets its transaction by purchasing another CDSfrom a separate counterparty. Accordingly, that second offsetting transaction is a nakedswap. Without the ability to offset itself with a naked swap, the original seller might notenter into a transaction with the original hedging party. In this way, naked CDS help to

keep the CDS market liquid and functional. Therefore, one the one hand, prohibitingnaked CDS would minimize systemic risk because the CDS market would shrinkdramatically, but on the other hand, the market could very possibly shrink out ofexistence.

C. Public Disclosure Of CDS Trades

On November 15, 2008, the leaders of the Group of Twenty (G-20)112 made apublic declaration that we will strengthen financial market transparency, including byenhancing required disclosure on complex financial products [ i.e., CDS] and ensuringcomplete and accurate disclosure by firms of their financial conditions.113 Securities

and Exchange (SEC) Director Erik Sirri testified before Congress last month andrequested authority to implement a mandatory system of record keeping and reporting ofall CDS trades to the SEC.114 Stephen Schwarzman, CEO of the private equity giantBlackstone Group, penned a Wall Street Journal editorial demanding full disclosure ofCDS to regulators.115 Indeed, countless public figures and academics have proposed thatfull disclosure on CDS trades be reported to government regulators, and their motivationsfor disclosure are in unison: no regulator can do its job of assessing risk and systemicsoundness if a large part of the financial markets are invisible to it.116 This Paper alsosupports CDS trading disclosure, but does not recommend that the information becomepublicly available.

Some financial commentators consider the securities laws of the 1930s as anappropriate model for regulation eliminating CDS systemic risk.117 The securities laws of1933 and 1934 require full public disclosure of all publicly traded investments, theunderlying rationale being that complete information provides investors will sufficientopportunity to evaluate the merits of an investment.118 Following the Great Depression,these reforms were thought to play a central role in restoring trust in financial markets.119

112 The G-20 is a group of finance ministers and centers bank governors from 19 of theworlds largest national economies, plus the EU. See www.g20.org113G-20 Statement Following Crisis Talks, WALL ST.J., Nov. 15, 2008, available athttp://online.wsj.com/article/SB122677642316131071.html.114 Sirri (2008), supra note 15.115 Stephen Schwarzman, Some Lessons of the Financial Crisis, WALL ST.J., Nov. 4,2008.116Id.117See, e.g., L. Gordon Crovitz, Credit Panic: Stages of Grief, WALL ST.J., Oct. 27,2008.118 Schwarcz (2004), supra note 99, at 12.119 Crovitz (2008), supra note 117.


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However, the distinction between then and now is that CDS are considered far morecomplex than securities from the 1930s.120 Most investors do not have the ability toevaluate CDS transactions;121 therefore disclosure alone may not be enough to remedythe information asymmetry between the originator and its investors. Besides, thoseinvestors who do understand CDS already demand the relevant disclosures from their

counterparties.

122

Rather, imposing public disclosure requirements on parties may provecounter-productive as it may compel parties to change their behavior. Disclosuredestroys firms propriety trading strategies. For example, Professor Schwarcz believesthat traders would become more cautious, demanding that prices move farther beforemaking trades, ultimately reducing market liquidity.123 Plus, complexity heightensambiguity, which thereby allows people to see what they are already inclined tobelieve.124 The result is that less experienced investors could be lulled into CDS trading,and in so doing lose their money in a relatively unproductive way.125

D. Confidential Disclosure of CDS Trades

Confidential disclosure of CDS positions to a government regulator, such as theFederal Reserve, is an efficient way to reduce systemic risk. At present, the FederalReserve, which is the government agency charged with maintaining stability in thefinancial system,126 has no clear view of the CDS market and therefore cannot properlydo its job. Disclosure would alleviate this problem, granting the Federal Reserveopportunity to identify areas of systemic risk in the CDS market with more specificityand precision than previously known to the public. The information facilities a betterweighing of the costs and benefits for certain types of CDS regulation going forward.

This Paper maintains that confidential disclosure would not hurt the efficiency ofthe CDS market to the same degree public disclosure would (see previous section,above). Still, confidential disclosure is not without its drawbacks. First, the useful datadisclosed would only be made available to a select group of government experts,depriving the rest of the public. In the context of CDS, the public could then effectivelylose its ability to form educated opinions and usefully participate in the regulatory

120See Schwarcz (2004), supra note 99, at 13. Conversely, one can imagine that largecompanies made similar arguments in 1933 when opposing the securities laws of 1933and 1934 that investors would not understand how to price the companys stock even ifthe company disclosed all information regarding its business and financials.121Id.122 Schwarcz (2008), supra note 8, FN 148, citingStuart A. McCrary, HEDGE FUNDCOURSE 255 (2005) (Investors may demand more disclosures [from private entities] [][and] receive as much information as would be disclosed if the investment wasregistered.).123Id., at 219.124 Schwarcz (2004), supra note 99, at 16.125See Richard Bookstaber, ADEMON OF OUROWN DESIGN:MARKETS,HEDGE FUNDS,AND THE PERILS OF FINANCIAL INNOVATION 221 (2007).126 Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).


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process. Second, the cost of preparing disclosure documentation could be a burden onCDS market participants. The SEC currently requires public traded companies todisclose their risk exposure to derivatives instruments such as CDS,127 and the costs ofthis disclosure currently average $50,000 per filing.128 The CDS disclosurescontemplated in this section will likely exceed those required by the SEC, since they

should also include information about specific transactions. Consequently, one couldexpect average filing costs to be in excess of $50,000 per firm.

E. Elimination Of OTC CDS Trading

This morning, November 20, 2008, Senate Agriculture Committee Chairman TomHarkin announced that this afternoon he will introduce a bill that would force all OTCderivatives, including CDS, onto regulated futures exchanges.129 This bill is quiteextraordinary, because this form of regulation, if not tempered, could itself causesystemic risk. Certainly, if all CDS traders willfully operated on transparent exchanges,then systemic risk is reduced (for explanation see section III.B., above). However,

almost 100% of CDS trades, worth trillions of dollars, are currently traded OTC. Toforce a mass migration onto exchanges, which would dramatically alter the CDSlandscape, destabilizes market participants expectations and could potentially trigger aneconomic collapse if not handled properly. Also, without empirical evidence, one cannotdetermine whether or not major market participants could or would efficiently trade on anopen exchange. OTC permits custom contracts, unlike an exchange, and informationregarding the fungibility of those contracts is currently unavailable (see section III.B.,above).

F. Exposure Limitations On Particular CDS Trades

Although no commentator has come forward to support this form of regulation,the author included, perhaps this proposal is still worthy of some examination. In thetraditional context of banking law, limits are placed on the amount of credit a bank mayextend to any single borrower.130 The limit diversifies the banks risks, thereby reducingthe possibility that any one borrower will bring down the bank.131 Applied to CDS, asimilar exposure limitation would restrict the size of any single position that a marketparticipant may make. Theoretically, this regulation could facilitate systemic stability bydiversifying the risk of any counterparty, in turn minimizing the potential for entity-levelfailure. 132

127 Item 305 of SEC Regulation S-K. 17 C.F.R. 229.305 (2003).128 Schwarcz (2004), supra note 99, at 19.129 Sarah Lynch, Harkin Seeks to Force All Derivatives Onto Exchanges, WALL ST.J.,November 20, 2008.130 See, for example, 12 U.S.C 84.131 Carnell (2009), supra note 8, at 296.132 Schwarcz (2008), supra note 8, at 222.


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The most noticeable difficulty with this proposal is that even supposing a partyhas diversified its risks among various counterparties and various reference entities, theparty could still have 100% of its assets exposed to the CDS market. Therefore, aprolonged market shock has the clear potential to bankrupt that party. The costs of thisproposal (regulatory oversight and firms efficiency loss, for example) ultimately

outweigh the benefits. Instead, requiring firms to maintain a certain level of capitalreserves is a better way to restrain their ability to create systemic risk. The next sectionappraises this method.

G. Increased Capital Reserve Requirements For Market Participants Involved in thePurchase Or Sale of CDS Tied To Highly Speculative (Junk) Debt133

For this section, capital refers to the difference between a firms total assets andits total liabilities.134 To illustrate, if a firm has six dollars in assets and five dollars inliabilities, the firm thus has one dollar in capital. Capital is a valuable cushion that allowsfinancial institutions to absorb losses. When an institution has no capital, a loss can

quickly drive it into bankruptcy. Therefore, in the CDS market, the more capital that aninstitution has equates to the greater likelihood it will be able to pay collateral as its CDScontracts decrease in value.

Increasing capital reserve requirements on CDS market participants is an intuitiveand straightforward way to minimize systemic risk to prevent large participants fromfailing. However, this is not the only reason to adopt capital reserve requirements. ThisPaper contends that only capital reserve requirements can also prevent CDS fromencouraging the growth of dangerous asset bubbles.

As described in section I.E.1, above, banks that hedge their risky loans with CDShave the capacity to promote large asset bubbles, which are dangerous to the financialsystem. To review, CDS can decrease the lending standards of banks, because banksrealize that CDS ensure the bank will receive total value for the loan regardless ofdefault. Therefore banks will lend more freely to unworthy junk borrowers, andpossibly at lower interest rates (to compete effectively against other banks). Onceinterest rates decrease, junk borrowers will use cheap credit to purchase assets. As cheapcredit persists, the assets eventually become overvalued and a bubble is created.

Banking law currently imposes minimal capital reserve requirements on all banks,but this Paper submits that reserve requirements should be specially increased for thosebanking institutions and market participants that are involved in the purchase and sale ofCDS referenced to junk debt. In general, increasing capital reserve requirementsdecreases total lending. However, a total decrease in lending is an unnecessary loss ofefficiency. (Sub-prime mortgage CDOs aside) Investment grade debt is usually not a

133 Unfortunately, the scope of this Paper precludes discussion regarding a reliablemethod for determining (1) what type of debt should be considered junk and (2) thecalculation of optimal capital reserve ratios.134 Carnell, supra note 8, at 255.


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destabilizing factor, because (1) junk borrowers are the primary perpetrators of assetbubbles and (2) junk debt is most likely to default. Therefore, increasing capital reserverequirements for CDS tied to junk debt provides disincentives for businesses to lend tojunk borrowers. Moreover, junk debt is more likely to default, and so buyers135 andsellers of CDS referenced to junk debt are better protected with an additional capital

cushion.

IV. Conclusion

Credit-default swap area valuable financial tool that has created system-widebenefits. At the same time, however, these derivative contracts have also created thepotential for relatively few market participants to destabilize the entire economic system.This Paper has explored (1) how CDS could hypothetically create systemic risk, (2) howCDS 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 thegrowth of dangerous asset bubbles, (2) causing the collapse or failure of an institutionthat is systemically significant, and (3) creating perverse incentives that subvert policiesundermining business law on a system-wide scale. This Paper has questioned whetherCDS helped support the growth of the sub-prime mortgaged-backed securities assetbubble that has been blamed for igniting the current financial crisis. Ultimately, there isevidence cutting both ways, thereby encouraging further research into the issue. Thesecond of these theoretical risks has certainly come into realization within the last fewmonths when the trillion-dollar company, AIG, destroyed itself by blundering in the CDSmarket and causing system-wide instability. As for the third theoretical risk, there iscurrently no empirical evidence that CDS has created perverse incentives on a system-wide scale.

How should the government regulate CDS to minimize systemic risk? Afterexamining seven distinct proposals, this Paper recommends that legislators require CDSmarket participants to (1) maintain increased capital reserve requirements when involvedin the purchase or sale of CDS tied to highly speculative debt; and (2) confidentiallydisclose their CDS positions to the Federal Reserve. Increasing the capital reserverequirements for companies that trade in junk-grade CDS is essential for two reasons.First, higher capital reserve requirements protect the solvency of systemically significantinstitutions that attempt to profit from the riskiest CDS. Second, specifically targetingCDS that are associated with the junk lending business will discourage banks fromextending cheap credit to unworthy borrowers, thereby reducing the potential for marketsto generate inefficient asset bubbles. As a second regulatory measure, confidential

135 Participants who purchase CDS tied to junk debt for hedging purposes can also benefitfrom extra capital reserves, because the debt may depreciate in value. In many CDStransactions, traders buy on margin. Thus if the debt underlying the CDS depreciates, theCDS will rise in value. As a result, the purchaser must hand over more collateral.


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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 bothmarket participants and society in general, the benefits of enhanced economic stability

are incalculable.

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Credit Default Swaps So Dear to Us, So Dangerous

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