Credit Default Swaps and Clearing

In an article from 2000, an investigative journalist from The Banker warned against the hidden dangers of credit default swaps (CDS). Although CDSs can be a useful financial instrument for the banking industry, the article warned of the anonymity of credit derivatives, lack of transparency, and the potential for disaster. In an unfortunately accurate conclusion, the journalist opined that a crisis might occur because banks may not put in place the proper risk control systems in time to avert a disaster. Fast forward eight years and the financial meltdown of 2008 developed into one of the largest economic disasters in history. Banks and other large market actors had taken risk and, in many cases, reckless financial positions that put them at the brink of bankruptcy. The ensuing bailout targeted some of the largest financial entities, but the damage to the financial markets had already occurred. While many individuals debate about what factors caused the financial meltdown, regulators and Congress pointed to CDSs as a contributing factor to the financial meltdown. At one point, American International Group, Inc. (AIG), owed in excess of $400 billion to counterparties in CDS contracts and this was money that AIG simply did not have. CDSs, as financial instruments, are both beneficial and detrimental. CDSs do not necessarily create instability, but the contracts can be conduits of instability by shifting the risk of default onto another entity. This receiving entity, on the other hand, can be ill-equipped to deal with this new risk, even though it views itself as capable. Regardless of the benefits of CDS transactions, the public viewed the financial derivative as dangerous. Due to the public’s anger, there was substantial impetuousness in Congress to create new legislation to prevent another market wide failure. Both the U.S. House of Representatives and U.S. Senate proposed their own pieces of legislation, and, in June of 2010, President Barack Obama signed the financial reform bill. Part I of this paper will discuss CDSs and the swap market. Part II will review the prior law, which governed CDSs, and the changes being made to this law by the financial reform bill. Part III will discuss, in a qualitative manner, how these changes will affect CDS contracts and the market for these contracts and whether clearing CDSs will adequately address the issues within the financial markets. Part IV will discuss the governance issues that still underlie the CDS markets and the impact of the new legislation on governance and trading