Credit Default Swaps (CDS), which have a history of less than two decades of existence, have, over the years, emerged as an engine driving the global credit derivatives markets.
The Credit Default Swap (CDS) market has exploded over the past decade to leaps and bounds. A credit default swap is defined as a type of credit derivative contract in which one party, called protection buyer, pays a periodic fee to another party, called protection seller, in return for compensation for default (or similar credit event) by a reference entity. This is roughly twice the size of the US stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion US treasuries market. In fact, the total market size of CDS (at $57tn) almost matches the combined gross domestic product of all nations at $65tn at the end of 2007.
However, the same CDSs are now being blamed for the collapse of Wall Street giants such as Lehman Brothers and turmoil at Bear Stearns, Merrill Lynch and AIG among a raft of other global financial institutions which ultimately led to an unprecedented crisis in the form of the global financial meltdown. In this wake, the US market regulator, Securities and Exchange Commission’s (SEC) former Chairman Christopher Cox has emphasized that the CDS market should be regulated. He suggests that the US Congress should pass a legislation which would make CDS market transparent and offer more information for market participants. More importantly, the new legislation should ensure that the regulator gets the power to curb fraudulent or manipulative trading practices.
As the clamor for reining in CDSs gathers momentum the pressure is mounting on the authorities and policymakers to take urgent steps. To begin with, there were even talks of merging SEC and the Commodity Futures Trading Commission (CFTC). This was proposed by former US Treasury Secretary Henry Paulson. Though it received tepid response initially but is gaining momentum, Experts say combined CFTC-SEC would result in more efficient and effective regulation of the financial markets. They further said that “the key differences between SEC and futures overseen by the CFTC have blurred over the past few decades.” Combining the two agencies would solve many of the legal issues and also would make it easier to set up swap exchanges. Besides, clearinghouses under one regulator could help with international cooperation. According to experts, in the past, disconnected US regulatory system has confused efforts to coordinate with other regulators globally.
While credit default swaps have come under scathing attack from various quarters and are being seen at the epicenter of the current global financial crisis, things may not be all that bad. “The idea that the industry lacks a central registry for over-the-counter (OTC) credit default swaps (CDS) is grossly misleading and has resulted in inaccurate speculation on a number of matters, including the overall size of the market, its role in the mortgage crisis…” According to the Depository Trust and Clearing Corporation (DTCC) of the US, “Less than 1% of credit default swap contracts currently registered in the Warehouse relate to particular residential mortgage-backed securities.” Besides, CDSs have also drawn flak for fueling excessive speculation in the market for derivative instruments.
Notwithstanding, amidst all the criticisms one fact which gets forgotten is that credit default swaps have played a crucial role in allowing banks to transfer the credit risk and hence clean their balance sheet. While there is no doubt, rampant speculation (and the current global financial crisis) has dealt a severe blow to its image, yet hope floats that sanity may sooner or later return to the CDS market. Also, greater transparency and better regulation are the need of the hour.
N Janardhan Rao, Lead Economist
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