Credit Derivatives Market Design, Creating Fairness and Sustainability

Abstract

Now that the first wave of the financial crisis has been resolved through the coordinated efforts of regulators and banks, it is important to address some of the systematic weaknesses of the current financial system. One such weakness is the inappropriate incentive effects of the market for credit derivatives, and in particular, for credit default swaps. As a risk management tool, credit derivatives were originally an effective means of diversifying lending risk. Credit derivatives have worked to cover exposures where there have been credit events of the underlying reference entities. To date, the global market for derivatives has operated largely without regulatory oversight; yet it is increasingly evident that deficiencies in the market contributed, at least in part, to the liquidity crisis in the financial sector, resulting in massive injection of public funds in numerous jurisdictions. As structural adjustments are being made to ensure long term financial stability, the credit derivative market needs timely, targeted, and effective adjustment, with a measure of regulatory oversight. Credit default swaps (CDS), by far the most common form of credit derivative, are illustrative. There are two critical points at which intervention is required. The first is at the purchase and sale stage, where there is a serious lack of transparency regarding both material adverse risks associated with the reference entity and material risk in respect of the protection seller’s ability to settle the CDS if a credit event occurs. There is also a lack of due diligence and disclosure by those who are recommending CDS products to less sophisticated purchasers. Second, at the point of settlement and restructuring proceedings, there is a threat to current public policy goals of rehabilitating financially distressed businesses where they are viable, given structural and incentive effects for derivatives that are both physically and cash settled. The disconnection between economic interest and legal interest runs contrary to fundamental insolvency law principles adopted by numerous jurisdictions. In this respect, there needs to be a balancing of public law principles, those advancing the goals of insolvency law and those advancing the effective operation of capital markets. At times they align, at others, they are in sharp disaccord. This brief article addresses these two issues, offering ten recommendations for immediate action. More fundamentally, there needs to be public debate regarding the “casino” aspect of the current market for credit derivatives.