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Credit Default Swaps: So Dear To Us, So Dangerous

Eric Dickinson

(Dickinson@law.fordham.edu)

Fordham Law School Professor Alan Rechtschaffen Derivatives and Risk Management November 20, 2008
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Electronic copy available at: http://ssrn.com/abstract=1315535

Paper 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 systemwide 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 nonintrusive 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.

This Paper Abstract replicates Part IV: Conclusion, infra. 2


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

Introduction By design, this [credit default swap] market, presumed to involve dealing among sophisticated 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 proprietary information can undercut innovations in financial markets just as it would in real estate markets. - 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 2 2008 This morning, on November 20, 2008, the Dow Jones Industrial Average is down 43.5% 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.4 U.S. Consumer prices have registered their largest one-month decline since before World War II, provoking fears of impending economic deflation.5 Meanwhile, the public is vigorously debating whether, and to what extent, unregulated credit default swaps (CDS)6 are responsible this financial crisis. As a reflection of this debate, the Google News service has accumulated over 4,370 online news articles about CDS written this year,7 U.S. Congress has held numerous hearings on the 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 to the CDS debate in the course of answering three questions:

Speech by Alan Greenspan, Regulation, Innovation, and Wealth Creation, Federal Reserve Website, Sept. 25, 2002, available at http://www.federalreserve.gov/boardocs/speeches/2002/200209252/default.htm 2 Alistair Barr, Greenspan Sees Serious Problems with CDS, Marketwatch.com, Oct. 23, 2008, available at http://www.marketwatch.com (enter search keywords Greenspan Testimony Credit Default Swaps, then follow first result). 3 See, e.g., Serena Ng et al, Stocks, Bonds Tumble to New Crisis Lows, WALL ST. J., Nov. 20, 2008. 4 See Christopher S. Rugaber, New Jobless Claims Hit 16 Year High, Newsday.com, Nov. 20, 2008, available at http://www.newsday.com/business/nybzjobless1121,0,2107423.story. 5 See Jon Hilsenrath, Prices Post Rare Fall; A New Test For The Fed, WALL ST. J., Nov 20, 2008. 6 As will be discussed in greater detail throughout this Paper, CDS are financial contracts that require one party to pay another in the event that a third party cannot pay its obligations. Throughout this paper, CDS will refer to credit default swaps in both the singular and plural form. 7 http://news.google.com (enter search terms credit default swaps, then sort by Past year). 3
Electronic copy available at: http://ssrn.com/abstract=1315535

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 in the past year. As a result, CDS have intensified the scope of the financial crisis. In hopes of minimizing further systemic collapse, this Paper recommends that CDS become regulated in a way that balances the efficiency of a free market with the goal of economic stability. 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 to highly speculative debt; and (2) confidentially disclose their CDS positions to the Board of 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 then examines theoretical bases for CDS-induced systemic risk. Because CDS have the potential to allow relatively small groups of market participants to make bets that can affect 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 too interconnected to let fail; and (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. B. Definition and Overview of Systemic Risk Systemic risk refers to the possibility of a sudden, often unexpected, event or series of events that disrupts financial markets, and thereby the efficient channeling of resources, to such a great degree that it causes a significant loss to, or collapse of, the real economy as a whole.8 Systemic collapse is distinct from regular financial loss or market volatility in that it affects most, if not all, people and market place participants. According to this working definition, systemic risk cannot be diversified away through financial markets. Historically, U.S. legislators have found a strong public interest in regulating systemic risk. For example, Congress enacted the Federal Deposit Insurance Act to help maintain confidence in the banking system and prevent the bank panics that plagued the Robert E. Litan et al., AMERICAN FINANCE FOR THE 21ST CENTURY, 98 (1997), as printed in Richard S. Carnell et al., THE LAW OF BANKING AND FINANCIAL INSTITUTIONS, 732 (4th ed. 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 of 1933 and 1934, where Congress determined that public disclosure relevant to the pricing of widely traded securities would keep financial markets operating efficiently enough to prevent 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.11 In general, there are two primary rationales for regulating systemic risk: (1) maximizing economic efficiency;12 and (2) protecting health and safety, given that the failure of a financial system could generate 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 third party cannot pay its obligations.14 The mechanics of CDS contracts are often likened to insurance policies: [T]he CDS buyer is buying protection and the CDS seller is selling protection against a default or other credit event with respect to the underlying debt obligations [(the debt of a reference entity)]. The buyer pays the seller a premium for this protection, and the seller only pays the buyer if there is a default or other credit event that triggers the CDS contract. The premium [the] cost of protection for the buyerincreases as the risk associated with the underlying obligation increases. In other words, as the creditworthiness of the underlying entity goes down, the cost of protection goes up. 15 CDS serve multiple uses. The following illustration describes how CDS can operate as a risk-hedging device, in a way similar to insurance: A bank issues a multiSee Carnell (2009), supra note 8, at 732. See Schwarcz (2008), supra note 8, at 205,06. 11 See, 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, citing Gillian K. Hadfield, Privatizing Commercial Law: Lessons from the Middle and the Digital Ages, 58 (Stanford Law School, John M. Olin Program on Law and Econ., Working Paper No. 195, 2000) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=220252 (The public value at stake in relationships between commercial entities [] is economic efficiency.). 13 See Schwarcz (2008), supra note 8, at 207. 14 Robert Pickel, Statement to the House Agricultural Committee, To Review The Role of Credit Derivatives in the U.S. Economy, Hearing, Oct. 15, 2008, available at http://agriculture.house.gov/hearings/statements.html. 15 Erik Sirri, Statement to the House Agricultural Committee, To Review The Role of Credit Derivatives in the U.S. Economy, Hearing, Oct. 15, 2008, available at http://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. The bank becomes concerned that General Mopeds will default on the loan, so negotiates the purchase of a CDS from a hedge fund. The terms of the CDS agreement provide that the bank will make small, semi-annual payments to the hedge fund. In turn, the hedge fund will 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 to particular borrowers in this way, system-wide benefits will result.16 Alan Greenspan opined 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 of CDS is that because they enable banks to lend with lower risk, liquidity in the banking industry increases.18 That is to say, banks are willing to lend more money to more businesses, thereby expanding businesses access to capital. But not only banks can use CDS as hedges. A ship building business for example, can purchase a CDS referenced to customers (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 partially protected from the consequential losses. CDS can also be used as a tool for investment or speculation. A CDS buyer could profit 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 the equivalent of a debt interest in a company without actually owning any debt instrument.19 In other words, the payment streams from CDS buyer are the equivalent of interest payments to a bondholder. And, like a bondholder, the CDS seller runs the risk that the issuer of the underlying debt obligation will default. D. The CDS Market As of this writing, CDS agreements are privately negotiated, and executed bilaterally in the over-the-counter (OTC)20 market. CDS are not currently traded on an

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 Foreign Relations, Nov. 19, 2002, available at http://www.federalreserve.gov/boarddocs/speeches/2002/20021119/default.htm. 18 See Partnoy (2008), supra note 16 at 1024. 19 See 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 Paper No. 122, 2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=10307221 [hereinafter Hu II]. 20 See, e.g., Overview and History of the OTCBB, OTC Bulletin Board Website, available at http://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 CDS transactions are sophisticated institutions. These participants primarily include globally active banks, financial holding companies, hedge funds, registered investment companies, 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 Goldman Sachs represent at least half of CDS trading volume.23 London and New York are at the center of CDS trading.24 Small, independent brokerages bring together counterparties to most CDS transactions.25 The standard practice according to most CDS agreements is that CDS counterparties must adjust collateral on a daily basis as the value of the agreement changes (as the reference entity becomes more or less likely to default).26 This practice helps to eliminate counterparty risk.27 For example, if a CDS contract rises in value because the reference entity becomes more likely to default, the CDS seller must provide increasing 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 to market settlement on a daily basis mitigates a single, large, end game payment as a default event draws near. Standard practice also indicates that counterparties post additional amounts of collateral as their own financial condition deteriorates.28 For instance, a company that has received a Triple-A rating by a national ratings agency will post less collateral than a Triple-B rated company. However, pursuant to the CDS agreement, if that same Triple-A rated company is downgraded, it is often required to post extra collateral. Beyond counterparty risk and market risk (the risk that the CDS contract will increase or decrease in value), market participants deal with at least two other nonsystemic risks: (1) legal risk; (2) assignment risk. Legal risk is the possibility that counterparties will find themselves in a legal dispute. Though current statistics on legal However, several groups are in the process of establishing CDS exchanges. See Section III.B, infra. 22 See, e.g., Noah L. Wynkoop, The Unregulables: The Perilous Confluence of Hedge Funds 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. 23 See Wynkoop (2008), supra note 22, at FN 92, citing Tim Weithners, Credit Derivatives, Macro Risks, and Systemic Risks, FED. RES. BANK OF ATLANTA ECON. REV., Fourth Quarter 2007, at 43, 64. 24 See Sirri (2008), supra at note 15. 25 See Liz Rappaport, Spotlight Shines on Swap Brokers, WALL ST. J., Nov. 13, 2008. 26 See 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 payment under the terms of the CDS agreement. 28 See Pickels (2008), supra at note 14.
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risk are difficult to obtain, in 2004 approximately 14% of credit events involved a legal dispute between CDS counterparties.29 This risk has hopefully decreased in the last few years, however, as CDS parties have gained experience and documentation became more standardized.30 Assignment risk refers to the danger that a counterparty will assign a CDS transaction without consent of the other party. Although most CDS agreements require counterparty consent prior to assignment, the practice of no-consent assignments has grown to approximately 40% of CDS trade volume.31 Such conduct leads to uncertainty as to the identity of counterparties, undermining the original parties market and counterparty risk assessments.32 The current size of the CDS market is difficult to calculate, given that trading is done OTC. However, in mid-September, the International Swaps and Derivatives Association (ISDA)33 reported that the current gross notional value of all CDS contracts is approximately $54.6 trillion.34 This value greatly exaggerates the amount of money that would need to be paid out should every CDS reference entity default, because the 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 (Reference Entity X) from Beta for $100, where the agreement provides that Alpha will receive $1 million from Beta if X defaults. The next day, the value of the CDS drops to $99. Beta then purchases a CDS (Reference Entity X) from Delta for $99, where the agreement provides that Beta will receive $1 million from Delta if X defaults. As a result of these two 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 $1 million (if X defaults) $99

Alpha

Beta

Delta

$1 million (if X defaults)

Figure 1: Alpha Hedges with Beta; Beta Offsets Risk with Delta Zdenka S. Griswold et al., Counterparty Risk Management Policy Group II: OTC Documentation Practices in a Changing Risk Environment, ALI Broker Dealer Regulation 187 (2006). 30 See 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 assignments without 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 documentation and lobby on behalf of its member firms, which include all major institutions that participate in the OTC derivatives markets See Pickels (2008), supra note 14. 34 ISDA Mid-Year 2008 Market Survey Shows Credit Derivatives at $54.6 Trillion, ISDA News Release, Sept. 24, 2008.
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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 Alpha the $1 million that it would be required to give to Beta (who would in turn have to give Alpha $1 million). The general idea of netting is to eliminate unnecessary transactions. 35
Alpha $1 million Delta

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 (as of 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 7,678,846,427 7,898 111,979,517,282 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 13 FRENCH REPUBLIC 21,649,394,270 5,906,755,480 515 14 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 5,957 25 IRELAND 17,295,994,579 4,600,476,623 628

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See, e.g,. Charles Davi, Netting Demystified, Derivative Dribble Blog, available at http://derivativedribble.wordpress.com/2008/10/24/netting-demystified. 9

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 entities is 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 their risks. Following the pattern of relative gross notional vs. net notional values for the above referenced entities, one can make an educated guess that the net notional value of all 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 three ways. While each type of systemic risk is distinct from the others, the common threat underlying 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, but should 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 lower risk. Banks can purchase CDS to effectively ensure that they will receive full value for the loan extended. Because of this insurance, a bank no longer needs to be concerned about the risk of borrower default just as long as the bank is able to find counterparties willing to sell CDS referenced to the loan. As a result, banks have incentive to extend as much credit to default-prone borrowers37 as legally possible.38 According to economic theory, such behavior can lead to the creation of dangerous asset bubbles. An asset bubble is a situation where an assets price exceeds the fundamental value of the asset.39 Fundamental value is defined as the expected value of all dividends that the asset will yield over its lifetime, discounted for present value.40 A traditional

DTCC Deriv/SERV Trade Information Warehouse Reports, DTCC Website, available at http://www.dtcc.com/products/deriserv/data/index.php. 37 Default-prone borrowers will pay higher interest rates than investment grade borrowers, further enriching banks. 38 Depending on where the bank obtained its charter, it must maintain a certain capital reserve 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). 40 Id.
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explanation for the cause of asset bubbles is expansionary monetary policy.41 In such a scenario, fractional reserve banks lower interest rates and provide increasing monetary liquidity. When interest rates go down, investors will leverage their capital by cheaply borrowing from banks and investing leveraged capital in assets such as real estate and equities. 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 their fundamental value. Inevitably, the central bank will raise interest rates, increasing the cost 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 the assets will plummet in value. History has repeatedly shown that the bursting of asset bubbles, if large enough, can collapse entire financial systems.42 This Paper posits that CDS have the same causal effect on asset bubbles as an expansionary monetary policy. As CDS decrease the lending standards of banks, banks will lend more freely to unworthy junk borrowers, and at lower interest rates (to compete effectively against other banks). Once interest rates go down, junk borrowers will use cheap credit to purchase assets. As cheap credit persists, the assets eventually become overvalued and a bubble is created. Furthermore, if investors use cheap credit to sell CDS to banks, the effect is magnified to an even greater degree because banks will then 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 sellers can no longer buy CDS to offset their own risks. The CDS market could potentially lock up and collapse as the cost of purchasing CDS becomes prohibitively high. No longer able to hedge against bad loans, such a development could then cause banks to raise interest 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 will increase borrowing costs and in so doing burst asset bubbles. 2. CDS Could Cause The Collapse Of An Institution That Is Too Big or Too Interconnected To Let Fail. Too big to fail is traditionally known as an expensive and unpopular U.S. policy centered on the idea that any one of the largest eleven American banks is too big let fail.43 If one of these banks is teetering on collapse, the U.S. government will probably step in and provide funds to keep the bank solvent. John LaWare, a former governor of the Federal Reserve System, describes why a large bank failure causes systemic risk: The ramifications of that kind of failure are so broad and happen with such lightning speed that you cannot after the fact control them. It runs the risk of See, e.g., Mark Buchanan, Why Economic Theory is Out of Whack, NEW SCIENTIST, July 19, 2008. 42 See, 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 at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=386902.
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bringing down other banks, corporations, disrupting markets, bringing down investment banks along with it [] We are talking about the failure that could disrupt 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 with other large firms poses systemic risk. For example, Professor Dombalagian of Tulane Law School contends that any of the largest securities firms are too interconnected to fail.45 Such firms are too interconnected to fail because they are counterparties to thousands upon thousands of transactions in numerous markets. Should a large firm fail to stand behind its transactions, chaos in those financials markets could result as counterparties attempt to unwind their transactions.46 As numerous parties attempt to sell their positions, market liquidity disappears. The result is that solvent, but suddenly illiquid market participants may default on their own obligations. This could lead to the failure of even more highly interconnected firms, spreading the crisis to other areas of the system. As mentioned in Part I.D., above, CDS transactions are traded almost exclusively in the OTC market. The OTC market is not transparent, and pricing information on CDS is not publicly available. Even according to sophisticated CDS traders, the market remains maddeningly opaque.47 For instance, many investors, creditors, and other business counterparties could be uncertain whether a lender has hedged its position with CDS. This lack of relevant information prevents the CDS market from uncovering the most competitive market prices,48 which leads one to the inescapable conclusion that at least some CDS are priced incorrectly when sold, or perhaps should not have been sold at all. Because the firms that trade a vast majority of CDS volume are firms that are generally considered either too interconnected to fail or too big to fail (maybe both),49 systemic risk is created when these firms price too many CDS incorrectly, and inadvertently subject themselves to unexpected risks. Said another way, if a large financial institution buys or sells too many CDS without properly anticipating the amount 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., May 9, 1991. 45 See generally Onnig H. Dombalagian, Too Interconnected to Fail?: Investment Banks and Systemic Risk, Working paper, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1249441. 46 Id. 47 Frank Partnoy et al., Credit Derivatives Play a Dangerous Game, FIN. TIMES, July 17, 2006. 48 See generally, Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, 25 J. FIN. 383 (1970). 49 See Section I.D, supra.
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of collateral that it will ultimately need to pay its counterparties, or without properly anticipating the risk that its counterparties would be unable to pay, the large institution could suddenly and unexpectedly be driven into insolvency. If the government does not step in and save the institution, such an event will adversely affect all of its counterparties, 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 due to lack of liquidity in the markets, the liquidity crisis spreads throughout the financial system. 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 of decreasing 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 that CDS 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 its borrower to stay out of bankruptcy and continue paying interest on its loans.52 Banking laws assume that a bank will carefully attempt to issue loans only to borrowers that will can repay both principal and interest, and that the bank will continue to monitor the borrower to make sure he does so.53 These assumptions are no longer valid now that CDS 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 debt contracts, as well as the right to participate in bankruptcy proceedings). Professors Hu and Black describe this separation as debt decoupling.54 Debt economic and control rights are decoupled when a creditor purchases a CDS, because while the creditor maintains control rights over the debt, the CDS seller effectively takes the economic interest in the debt the seller receives payment (albeit from the creditor) but also bears the risk of default on the underlying debt.

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. The participants in the CDS market is are some of the most interconnected in the entire economy. Notice in Figure 3, above, that the reference entity Goldman Sachs, to use as an example, has 9,895 outstanding CDS contracts referenced to it with a net notional value of $6.5 billion, but a gross notional value $94.0 billion. This means that the average CDS referenced to Goldman has been offset fourteen times; therefore fourteen firms are linked together on this chain of transactions. 51 See, 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). 52 Id. at 16. 53 See 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) subjecting contractual creditors to moral hazard, and (2) providing debtholders with a negative economic interest to affirmatively destroy value. Each of these issues will be discussed in turn. In the first instance, moral hazard is commonly defined as the tendency of insurance to alter the insureds behavior, or, more extensively, as the tendency to maximize ones own utility to the detriment of others when one does not bear the full consequences or enjoy the full benefits of ones actions.55 Moral hazard can be applied to a creditor who has hedged with CDS, in that the creditor has no interest in wasting its time and resources monitoring the borrower. The creditor does not care if the borrower defaults, because either way the creditor will be getting paid. However, because the CDS seller has no contractual relationship with the borrower, the CDS seller cannot play the role of monitor and make sure that the borrower does not squander the loan.56 For any one loan, this behavior is merely inefficient, and should be weighed against the benefits of 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 systemic risk.57 In the second instance, a negative economic interest is described as a creditor whose ownership of debt is less than his ownership of CDS insuring that underlying debt.58 Such a creditor stands to gain by sending the issuer of said debt into default or bankruptcy, triggering a CDS payout. For example, a creditor with a negative economic interest will almost certainly use its influence to force the company into bankruptcy rather than agree to restructuring or making concessions on the loan, regardless of social cost. 59 In this way, creditors with a negative economic interest can profit by destroying a productive, 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

See Richard S. Carnell, A Partial Antidote to Perverse Incentives: The FDIC Improvement Act of 1991, 12 ANN. REV. OF BANK L. 371 (1993). 56 But see Partnoy (2008), supra note 16 at 1040 (In theory, the counter-parties to a credit default swap could take up the slack, assuming the banks monitoring role along with their credit risk exposure.). A problem with this theory is that the borrower would have to assent to the CDS seller receiving confidential information. 57 See 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 of Credit Derivatives in the U.S. Economy, Hearing, Oct. 15, 2008, available at http://agriculture.house.gov/hearings/statements.html. 59 See Hu II (2008), supra note 19 at 788. But see, U.C.C. 1-203 (1977) (every contract is 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 only accelerate 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 the economy, 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 financial marketsin 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 subprime 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 shareholder value and further destabilized the world financial system. Other than AIG, CDS have not yet directly caused the failure of any large institution. However, this Paper predicts that if CDS prices rise to such a degree that participants 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 to a very large number of default-prone home mortgages.60 Billions upon billions of dollars worth of these high-risk loans were securitized (in the form of collateralized debt obligations (CDOs)) and sold to investors, thereby freeing up the balance sheets of lenders 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 financial institutions. Commentators still debate why investors were eager to purchase sub-prime CDOs that were likely to default,62 however it is undisputed that many CDO investors hedged their risk by purchasing CDS on the underlying debt.63 Yuliya Demyanyk et al., Understanding the Subprime Mortgage Crisis, Aug. 2008, Working paper, available at http://ssrn.com/abstract=1020396. 61 Id. 62 One theory is that investors had asymmetric information. Another theory is that investors knew the investments were bad, but nevertheless were irrationally tempted by the high-yield offered by these securitized assets. Id. 63 Hank Greenberg, Statement of Maurice R. Greenberg: Before the United States House of Representatives Committee on Oversight and Government Reform, Oct. 7, 2008, available at http://online.wsj.co/public/resources/documents/20081007101332.pdf; see also Isaac Lustgarden, De Facto Regulation of Hedge Funds Through the Financial Services Industry and Protection Against Systemic Risk Posed by Hedge Funds, 26 NO.
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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 the housing market was created.65 In 2007, once sub-prime borrowers began to default on their 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 subprime CDOs.67 Investors, including most large financial institutions, had to write down the value of these assets on their balance sheets to market value (which was close to zero). As a result of these write-downs, numerous large financial institutions became insolvent, including Bear Stearns, Freddy Mae, Fanny Mac, Lehman Brothers, Countrywide Mortgage, Merrill Lynch, and the list goes on. Systemic emergency has ensued, and to this day the crisis continues to grow. As mentioned above, many large financial institutions purchased CDS referenced to their CDO assets, perhaps believing that CDS would hedge their exposure to sub-prime CDOs. 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 theory proves to be valid, then it logically follows that CDS helped propagate sub-prime mortgage loans, their subsequent securitization, and ultimately the current financial crisis. C. Lehman Brothers Bankruptcy Lehman Brothers (Lehman), a giant among securities firms, with over 100 years of history, declared bankruptcy this past September after writing down the asset values of its numerous sub-prime mortgage CDOs.69 The bankruptcy was a watershed moment in CDS history because it was by far the largest credit event to test the functioning of the market. Practicing attorneys in the field of derivatives litigation

10 BANKING & 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 a bet that conditions [in the sub-prime market] will improve or will not further deteriorate as some people think.); but see Gregory Zuckerman, Paulson & Co. Scores Again This Year, 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 companies and possibly sub-prime CDOs as well.). 64 See Section I.E.1, supra. 65 See Demyanyk (2008), supra note 60, at 48. 66 Larry Elliott, Credit Crisis- How It All Began, THE GUARDIAN, August 5, 2008 available at http://www.guardian.co.uk/business/2008/aug/05/northernrock.banking. 67 Id. 68 Unfortunately, to the authors knowledge, no empirical studies have been conducted on this specific issue. 69 See, Carrick Mollenkamp et al., Lehmans Demise Triggered Cash Crunch Around Globe, WALL ST. J., Sept. 29, 2008. 16

believed that systemic risk in the CDS market has moved from possible to probable.70 Nevertheless, despite the Lehman bankruptcys paralyzing impact on scores of financial markets,71 two months later the CDS market appears to have emerged relatively unscathed.72 Lehmans bankruptcy affected the CDS market on two levels. First, the bankruptcy is certainly a credit event that triggered all CDS tied to Lehmans outstanding debt issuances. Because there had never been a CDS credit event referenced to an entity the size of Lehmans debt, approximately $400 billion,73 practitioners were very concerned that one or more large institutional counter-parties would default their resulting obligations, resulting in a domino effect.74 Nonetheless, on October 22, 2008, the DTCC75 successfully completed the automated settlement of all CDS related to Lehman credit events.76 After netting, only $5.2 billion actually transferred hands.77 There have been no public reports of any institution defaulting on its obligations as a result of the settlement. Financial commentator Felix Salmon describes the settlement as the 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 contract changes value. Therefore, as the Lehman CDS rose in value (and as Lehman approached default), CDS sellers would have already paid out most of the contract value to counterparties. Therefore the non-event of the year merely refers to margin settlement related to the day Lehman actually declared bankruptcy, which may not have been such a surprise 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 satisfy obligations to its counterparties. Kevin LaCroix, a CDS trader, opines that Lehman was

Timothy W. Mungovan et al., Problems and Opportunities in the Credit Default Swap (CDS) Market (Sept. 17, 2008), available at http://www.nixonpeabody.com (navigate to Client Alerts on home page). 71 See Andrew Ross Sorkin et al., 36 Hours of Alarm and Action as Crisis Spiraled, N.Y. TIMES, Oct. 2, 2008, at A1. 72 See, e.g., The Meltdown That Wasnt, WALL ST. J., Nov. 15, 2008 [hereinafter Meltdown]. 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 DTCC Website, available at http://www.dtcc.com 76 DTCC Process Credit Event for Lehman Brothers, DTCC Website, Oct. 22, 2008, available at http://www.dtcc.com/news/newsletters/dtcc/2008/oct/lehman_credit_event.php. 77 Id. 78 Salmon (2008), supra note 26. 79 Id.
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the type of blue chip company that would not usually need to offer collateral.80 As such, Lehmans default could have particularly injured its CDS counterparties, but fortunately this scenario did not come to pass. Under U.S. bankruptcy law, the counterparties to a failed firm like Lehman are able to net-out payments owing to and from the bankrupt counterparty without requiring approval from the bankruptcy judge.81 Furthermore, CDS counterparties may legally foreclose on collateral that the bankrupt party posted.82 These two protections help prevent counterparties from taking large nonmarket losses. However, it seems that a third development played the larger role in protecting Lehmans counterpartiesBarclays September 16th acquisition of Lehman Brothers 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) trading and research operations division, Barclays Bank provided Lehman with $500 million in debtor-in-possession financing, as well as a substantial interim credit facility to fund Lehmans ongoing operations.84 This support has probably provided Lehman with the necessary resources to continue operating as a stable CDS counterparty. The Lehman Brothers bankruptcy illustrates how the CDS market continues to operate efficiently85 in the midst of a financial crisis, even after a major market participant simultaneously went bankrupt and triggered the CDS on one of the markets largest reference entities. On the other hand, while the CDS market is still functioning today, if one large market participant collapses without credit support from another large institution (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 largest insurance company, offer the first-ever instance of an institution that is too interconnected to fail acting to devastate itself, its shareholders, U.S. taxpayers, and the greater financial system simply by the misuse of CDS. As a result, one of the most successful companies in business history,86 with over $1 trillion in assets,87 has been almost entirely nationalized.

Alan Rappeport, Systemic Risk Haunts Credit-Default Swaps, CFO.com, Sept. 18, 2008, available at http://www.cfo.com/printable/article.cfm/12280060. 81 See, e.g., Pickel, supra note 14. 82 Id. 83 See Barclays to Acquire Lehman Brothers Business and Assets, Lehman Brothers Press Release, Sept. 16, 2008, available at www.lehman.com (navigate to News at homepage). 84 Id. 85 See Meltdown, supra note 72. 86 AIGs market capitalization increased 40,000 percent between 1969 and 2004. See Greenberg, supra note 63. 87 Id.
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In 1998, a subsidiary of AIG, AIG Financial Products (AIGFP), began selling CDS. From 1998-2005, while Hank Greenberg operated as CEO, the CDS business operated very conservatively. But upon Mr. Greenbergs retirement, the sale of CDS exploded, and between 2005 and 2007 AIGFPs net notional exposure to sub-prime mortgages 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 and his team put in place, such as weekly meetings to review all of the companys risks and investments.90 The Wall Street Journal has stated that AIGs sub-prime CDS exposures skyrocketed because AIGFPs risk models were flawed.91 Either way, by August 2008 AIG had posted $16.5 billion in total collateral on CDS.92 Shortly thereafter, on September 16, 2008, ratings agencies slashed AIGs credit ratings.93 That same day, pursuant to CDS contracts, counterparties demanded more collateral than AIG had available. Thus, rather than declare bankruptcy, AIG sought a bailout from the U.S. government.94
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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 the effects would be mind boggling [] They [would] take everything with it.96 Now the U.S. Treasury has a 79.9% ownership interest in AIG and stands behinds AIGs obligations to counterparties. Perhaps the too big to fail policy97 has saved the world from immediate economic destruction after all. However, AIGFPs mis-priced CDS have nonetheless destroyed many investors confidence in the financial system,98 further drying 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 other various, large, failed institutions, such as Bear Stearns, Countrywide Mortgage, and many more. Yet systemic risk remains. If a large CDS market participant completely folds without any third party support, the CDS market may fall apart as counterparties to the See Carrick Mollenkamp et al., Behind AIGs Fall, Risk Models Failed to Pass Real World Test, Wall St. J., Nov. 3, 2008. 89 See Greenberg, supra note 63. 90 Id. 91 See Mollenkamp, supra note 88. 92 Id. 93 Id. 94 See, e.g., Pickel, supra note 14. 95 Elizabeth Strott, Why AIG Matters, MSN Money, Sept. 16, 2008, available at http://articles.moneycentral.msn/com/investing/dispatch/why-aig-matters.aspx. 96 Id. 97 See section I.E., supra 98 See Strott, supra note 95.
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failed firm try to unwind their positions and take losses. This chaos could pull another large institution in into insolvencyespecially if it was relying on either collateral from the failed firm or the ability to use the CDS market to offset risk leading to a domino effect 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) selfregulation; (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 above proposals, 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 trading information 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 has argued that self-regulation (i.e., non-governmental regulation) of CDS and the derivatives markets is sufficient to curtail systemic risk, for the reason that government intervention is both pointless and wasteful.99 Professor Baird submits that our understanding of capital structures is simply too primitive for us to do much more than enforce the contracts as they are written as best we can. [] Imposing [regulations] that are too rigid or too mechanical may limit the ability of investors to create capital structures that are beyond the ken of those writing the rules.100 Moreover, even if regulators could gain a complete understanding of the complex interplay between CDS and the rest of the economy, Professor Davidoff reasons that regulatory efforts would be futile because See, e.g., Douglas G. Baird, Other Peoples Money, 60 STAN. L. REV. 1309 (2008); Steven M. Davidoff, Paradigm Shift: Federal Securities Regulation In the New Millennium, 2 BROOK. J. CORP. FIN. & COM. L. 339 (2008); Griswold, supra note 29; Lustgarten (2007), supra note 63; John T. Lynch, Credit Derivatives: Industry Initiative Supplants Need For Direct Regulatory InterventionA Model For the Future of U.S. Regulation?, 55 BUFF. L. REV. 1371 (2008); Steven L. Schwarcz, Rethinking the Disclosure 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 mimic the prohibited or [regulated] investment.101 Following an alternative line of reasoning, some legal theorists believe that the risk management initiatives of private financial institutions are the most efficient and effective method of diminishing systemic risk, because not only do financial institutions understand the market better than any regulator, but also it is in the best interests of industry players to minimize risk.102 The business press has largely adopted this rationale, praising the recent efforts of CDS counterparties that have increased their collateral requirements, improved record keeping, and demanded approval over assignment of CDS assignments.103 In recent weeks there has been much news coverage regarding how several groups are competing to create a relatively transparent CDS exchange.104 The New York Federal Reserve has supported this specific private initiative, as long as the exchange includes a central counterparty (CCP) to clear trades: [A CCP] will help reduce systemic risk associated with counterparty credit exposure 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 market would collapse if/when a large market participant defaults on its obligations,106 other systemic 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 shocked numerous financial markets. A CCP cannot always prevent that occurrence, but can only help to keep the CDS market from devastation. Also, there is no clear evidence indicating that a majority of CDS trades will move from OTC to an exchange. OTC allows for highly customized contracts, whereas exchanges only trade standardized, fungible CDS. Unless large institutions find it more efficient to do most of their trading on an exchange, the proposed CDS exchanges will not impact systemic risk one way or the other. Furthermore, a CDS exchange and CCP cannot prevent the build up of dangerous asset bubbles like the sub-prime CDO market. These measures merely Davidoff (2008), supra note 99, at 345. See generally Lynch, supra note 99 . 103 See, 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. 104 See, 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 CDS Counterparty, REUTERS, Oct. 6, 2008, available at http://www.reuters.com/articlePrint?articleId=USN0655208920081006. 105 Linnane (2008), supra note 104. 106 See, e.g., Sirri (2008), supra note 15 (A central counterparty could further reduce systemic risk by novating trades to the CCP, meaning that Dealers X and Y no longer are exposed to each others credit risk. In addition, the CCP could reduce the risk of collateral flows by netting positions in similar instruments, and by netting all gains and losses across different instruments.).
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facilitate the operation of the CDS market, but cannot discriminate which CDS trades would ultimately encourage a misallocation capital in other markets. Finally, self-regulation as a general proposition cannot sufficiently curtail systemic risk because of an incentives problem popularly known as the tragedy of the commons.107 According to this theoretical problem, multiple individuals acting independently in their own self-interest can ultimately destroy a shared resource even where it is clear that it is not in anyones long-term interest for this to happen. The classic example begins with numerous herders sharing a common parcel of land.108 It is in each herders interest to put as many cows as possible onto the land to graze, even if the commons is destroyed as a result. This is because the herder receives all of the benefits from the added cows, whereas the cost of the destroyed commons is shared by all of 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 the benefits if the bets pay off, while everyone shares the cost of a financial collapse if the bets 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 systemic risk, 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 CDS in such a way is inefficient to the point where the costs of regulation clearly outweigh the benefits. Hedging and speculating CDS parties are inextricably meshed in the CDS market. Without one, the other would be greatly injured. Hedging parties create an economic purpose for the existence of the market (efficient risk-spreading), while speculative traders offer the needed liquidity for the market to function. A short time ago, the New York Insurance Department (NYID) proposed that federal regulators prohibit naked CDS (i.e., CDS entered into purely for speculative purposes).110 NYID Superintendent Eric Dinallo noted that naked CDS do not spread and therefore minimize risk to parties, but instead create risk.111 This conclusion is both true and false. Systemic risk aside, CDS is a zero-sum transaction. Therefore it will always create risk for at least one of the parties. However, naked swaps create liquidity in the market so that hedging CDS can be purchased at an efficient price. To clarify, the great majority of CDS are offsetting transactions. Only a small percentage of CDS involve a 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. 108 See Hardin (1968), supra note 107. 109 See Schwarcz (2008), supra note 8, at 219, 220; Liskov, New Regulation of Credit Default 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. 111 Id.
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hedging purchaser (such as a bondholder). However, the counterparty that sells the CDS to that hedged party almost inevitably offsets its transaction by purchasing another CDS from a separate counterparty. Accordingly, that second offsetting transaction is a naked swap. Without the ability to offset itself with a naked swap, the original seller might not enter 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, prohibiting naked CDS would minimize systemic risk because the CDS market would shrink dramatically, but on the other hand, the market could very possibly shrink out of existence. C. Public Disclosure Of CDS Trades On November 15, 2008, the leaders of the Group of Twenty (G-20)112 made a public declaration that we will strengthen financial market transparency, including by enhancing required disclosure on complex financial products [ i.e., CDS] and ensuring complete and accurate disclosure by firms of their financial conditions.113 Securities and Exchange (SEC) Director Erik Sirri testified before Congress last month and requested authority to implement a mandatory system of record keeping and reporting of all CDS trades to the SEC.114 Stephen Schwarzman, CEO of the private equity giant Blackstone Group, penned a Wall Street Journal editorial demanding full disclosure of CDS to regulators.115 Indeed, countless public figures and academics have proposed that full disclosure on CDS trades be reported to government regulators, and their motivations for disclosure are in unison: no regulator can do its job of assessing risk and systemic soundness if a large part of the financial markets are invisible to it.116 This Paper also supports CDS trading disclosure, but does not recommend that the information become publicly available. Some financial commentators consider the securities laws of the 1930s as an appropriate model for regulation eliminating CDS systemic risk.117 The securities laws of 1933 and 1934 require full public disclosure of all publicly traded investments, the underlying rationale being that complete information provides investors will sufficient opportunity 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 The G-20 is a group of finance ministers and centers bank governors from 19 of the worlds largest national economies, plus the EU. See www.g20.org 113 G-20 Statement Following Crisis Talks, WALL ST. J., Nov. 15, 2008, available at http://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. 116 Id. 117 See, 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 more complex than securities from the 1930s.120 Most investors do not have the ability to evaluate CDS transactions;121 therefore disclosure alone may not be enough to remedy the information asymmetry between the originator and its investors. Besides, those investors who do understand CDS already demand the relevant disclosures from their counterparties.122 Rather, imposing public disclosure requirements on parties may prove counter-productive as it may compel parties to change their behavior. Disclosure destroys firms propriety trading strategies. For example, Professor Schwarcz believes that traders would become more cautious, demanding that prices move farther before making trades, ultimately reducing market liquidity.123 Plus, complexity heightens ambiguity, which thereby allows people to see what they are already inclined to believe.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 the Federal Reserve, is an efficient way to reduce systemic risk. At present, the Federal Reserve, which is the government agency charged with maintaining stability in the financial system,126 has no clear view of the CDS market and therefore cannot properly do its job. Disclosure would alleviate this problem, granting the Federal Reserve opportunity to identify areas of systemic risk in the CDS market with more specificity and precision than previously known to the public. The information facilities a better weighing of the costs and benefits for certain types of CDS regulation going forward. This Paper maintains that confidential disclosure would not hurt the efficiency of the CDS market to the same degree public disclosure would (see previous section, above). Still, confidential disclosure is not without its drawbacks. First, the useful data disclosed 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 effectively lose its ability to form educated opinions and usefully participate in the regulatory See Schwarcz (2004), supra note 99, at 13. Conversely, one can imagine that large companies made similar arguments in 1933 when opposing the securities laws of 1933 and 1934 that investors would not understand how to price the companys stock even if the company disclosed all information regarding its business and financials. 121 Id. 122 Schwarcz (2008), supra note 8, FN 148, citing Stuart A. McCrary, HEDGE FUND COURSE 255 (2005) (Investors may demand more disclosures [from private entities] [] [and] receive as much information as would be disclosed if the investment was registered.). 123 Id., at 219. 124 Schwarcz (2004), supra note 99, at 16. 125 See Richard Bookstaber, A DEMON OF OUR OWN 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 on CDS market participants. The SEC currently requires public traded companies to disclose their risk exposure to derivatives instruments such as CDS,127 and the costs of this disclosure currently average $50,000 per filing.128 The CDS disclosures contemplated in this section will likely exceed those required by the SEC, since they should also include information about specific transactions. Consequently, one could expect 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 Tom Harkin announced that this afternoon he will introduce a bill that would force all OTC derivatives, including CDS, onto regulated futures exchanges.129 This bill is quite extraordinary, because this form of regulation, if not tempered, could itself cause systemic 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. To force a mass migration onto exchanges, which would dramatically alter the CDS landscape, destabilizes market participants expectations and could potentially trigger an economic collapse if not handled properly. Also, without empirical evidence, one cannot determine whether or not major market participants could or would efficiently trade on an open exchange. OTC permits custom contracts, unlike an exchange, and information regarding 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 the traditional context of banking law, limits are placed on the amount of credit a bank may extend to any single borrower.130 The limit diversifies the banks risks, thereby reducing the possibility that any one borrower will bring down the bank.131 Applied to CDS, a similar exposure limitation would restrict the size of any single position that a market participant may make. Theoretically, this regulation could facilitate systemic stability by diversifying the risk of any counterparty, in turn minimizing the potential for entity-level failure. 132

Item 305 of SEC Regulation S-K. 17 C.F.R. 229.305 (2003). 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 party has diversified its risks among various counterparties and various reference entities, the party could still have 100% of its assets exposed to the CDS market. Therefore, a prolonged market shock has the clear potential to bankrupt that party. The costs of this proposal (regulatory oversight and firms efficiency loss, for example) ultimately outweigh the benefits. Instead, requiring firms to maintain a certain level of capital reserves is a better way to restrain their ability to create systemic risk. The next section appraises this method. G. Increased Capital Reserve Requirements For Market Participants Involved in the Purchase Or Sale of CDS Tied To Highly Speculative (Junk) Debt133 For this section, capital refers to the difference between a firms total assets and its total liabilities.134 To illustrate, if a firm has six dollars in assets and five dollars in liabilities, the firm thus has one dollar in capital. Capital is a valuable cushion that allows financial 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 an institution has equates to the greater likelihood it will be able to pay collateral as its CDS contracts decrease in value. Increasing capital reserve requirements on CDS market participants is an intuitive and straightforward way to minimize systemic risk to prevent large participants from failing. However, this is not the only reason to adopt capital reserve requirements. This Paper contends that only capital reserve requirements can also prevent CDS from encouraging the growth of dangerous asset bubbles. As described in section I.E.1, above, banks that hedge their risky loans with CDS have the capacity to promote large asset bubbles, which are dangerous to the financial system. To review, CDS can decrease the lending standards of banks, because banks realize that CDS ensure the bank will receive total value for the loan regardless of default. Therefore banks will lend more freely to unworthy junk borrowers, and possibly at lower interest rates (to compete effectively against other banks). Once interest rates decrease, junk borrowers will use cheap credit to purchase assets. As cheap credit 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 those banking institutions and market participants that are involved in the purchase and sale of CDS referenced to junk debt. In general, increasing capital reserve requirements decreases total lending. However, a total decrease in lending is an unnecessary loss of efficiency. (Sub-prime mortgage CDOs aside) Investment grade debt is usually not a
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Unfortunately, the scope of this Paper precludes discussion regarding a reliable method for determining (1) what type of debt should be considered junk and (2) the calculation of optimal capital reserve ratios. 134 Carnell, supra note 8, at 255. 26

destabilizing factor, because (1) junk borrowers are the primary perpetrators of asset bubbles and (2) junk debt is most likely to default. Therefore, increasing capital reserve requirements for CDS tied to junk debt provides disincentives for businesses to lend to junk borrowers. Moreover, junk debt is more likely to default, and so buyers135 and sellers of CDS referenced to junk debt are better protected with an additional capital cushion. IV. Conclusion Credit-default swap 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 has explored (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 undermining business law on a system-wide scale. This Paper has questioned 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 systemwide 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 inefficient asset bubbles. As a second regulatory measure, confidential

Participants who purchase CDS tied to junk debt for hedging purposes can also benefit from extra capital reserves, because the debt may depreciate in value. In many CDS transactions, traders buy on margin. Thus if the debt underlying the CDS depreciates, the CDS 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 nonintrusive 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.

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