Credit derivatives and the Dodd–Frank Act: Is the regulatory response appropriate?

Abstract

Credit derivatives played an important role in the Credit Crisis of 2008-09. The US Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 as a comprehensive response to the Credit Crisis. Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS), which are among the major credit derivatives developed by the financial industry in the recent decades, are among the subjects covered in the lengthy Dodd-Frank legislation. Regulation seeks to streamline trade in derivatives and promote smooth clearing and settlement of transactions. There is little effort either to identify the systemic risk in credit derivatives or to address the issue of risk.In this paper, I review the measures proposed in the Dodd-Frank Act for regulating credit derivatives and question their adequacy. The Dodd-Frank Act merely attempts to improve the procedures or mechanics governing the trade in credit derivatives and promote prudential standards for the entities dealing in swaps. These are obviously inspired by experience – namely, freezing of the market during the Credit Crisis and companies such as AIG issuing Credit Default Swaps without serious concern about their ability to honor the obligations assumed under the contracts.The issue is whether the regulatory response is adequate from a systemic perspective. This question is important if the goal is to prevent a recurrence of events like the Credit Crisis and the events that led up to the Crisis. In considering this question, a major issue with the Dodd-Frank Act is its failure to sufficiently address the character of the swap instruments, in particular the credit derivatives as they were developed in the market and the risk potential that is engineered in them.I present a proposal in the paper for a screening procedure before the launch of financial instruments. Screening can help generate an informed and reasonably disinterested debate on the planned instruments, and this can lead to a better understanding of their characteristics and risk potential. The procedure would not seriously interfere with the freedom of the market to innovate and devise new financial products, but at the same time it can instill elements of caution and deliberation in the process. The paper also deals with other issues such as the transaction cost of the screening process, any intellectual property rights in the new products and a more basic constitutional issue – the liberty of contract.