Filling a Regulatory Gap: It is Time to Regulate Over-The-Counter Derivatives by North Carolina Banking Institute

Book Review : Filling a Regulatory Gap: It is Time to Regulate Over-The-Counter Derivatives

By North Carolina Banking Institute

  • Publication Date: 2009-03-01
  • Genre: Industries & Professions

Book Review

The recent credit crisis has highlighted the lack of regulation for credit default swaps that has both magnified and contributed to market failure that began in the latter half of 2008. (1) Securities regulation covers most types of investment contracts, but currently does not include non-securities based derivative contracts such as credit default swaps. (2) The unique aspect of credit default swaps is that unlike other risk shifting contracts such as insurance, they are not regulated. The diverse regulatory schemes for insurance, securities, and commodities futures contracts do not cover over-the-counter credit default swaps. Thus, even though like insurance, left unregulated, credit default swaps run the risk of being nothing more than a form of legalized gambling. This essay examines the regulation of instruments similar to credit default swaps and concludes that credit default swaps should be regulated as well. A credit default swap (CDS) is a derivative investment that has been the topic of much discussion over the past several months. Unregulated CDSs have been justified as a useful device for dealing with risk. There are many other risk shifting devices including traditional insurance. Insurance, of course is a regulated activity, with state-based insurance regulation. (3) There currently is increasing sentiment to regulate the CDS market. Securities and Exchange Commission Chairman Cox has called for a centralized regulated CDS clearing system. (4) The President's Working Group on the credit crisis also proposed centralizing the CDS market. New York State announced plans to regulate CDS transactions as insurance but has since decided to delay that action. But why limit the discussion relating to swap regulation to the CDS markets? Unregulated derivatives include over-the-counter foreign currency (Forex) contracts, interest rate swaps, equity swaps, and other highly complex derivatives that may equally warrant some sort of regulation. The discussion below explains why regulation of the over-the-counter derivatives markets is warranted.

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