On the necessity to regulate credit derivatives markets

Abstract

This paper reviews prevailing credit derivatives markets regulation and comments on the need to regulate these markets in light of the recent financial crisis. Although credit derivatives may have beneficial effects such as enhancing the resilience of the financial system, these benefits can only be reaped if credit derivatives are used prudently and responsibly by all market participants. We argue that the current regulatory regime is not sufficient to induce market participants to use credit derivatives in a desirable way. Rather, the existing system, which is mainly based on self-regulatory initiatives, should be accompanied by supervisory action such as the introduction of mandatory disclosure of credit derivative transactions or collateral requirements for all credit derivative transaction counterparties. The combination of self-regulatory initiatives together with strict supervisory action seems to be well suited to help in preventing market participants from misusing credit derivatives, therewith dampening the dangers these instruments might pose to the stability of the financial system.