Subprime Mortgage Crisis Solutions Debate - Regulation - Derivatives Regulation - Arguments For Regulating Credit Derivatives

Arguments For Regulating Credit Derivatives

Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003. Former President Bill Clinton and former Federal Reserve Chairman Alan Greenspan indicated they did not properly regulate derivatives, including credit default swaps (CDS). A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.

Economist Joseph Stiglitz summarized how CDS contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."

NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems.... In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations.

Financier George Soros has recommended that credit default swaps no longer be traded, calling them "instruments of destruction that ought to be outlawed."

U.S. Treasury Secretary Timothy Geithner proposed a framework for legislation to regulate derivatives during May 2009, stating that "...derivatives are largely excluded or exempted from regulation." Key elements of the framework include:

• Require clearing of all standardized over-the-counter (OTC) derivatives through regulated central counterparties (CCPs);
• Robust margin and capital requirements for key market participants;
• Financial reporting and disclosure requirements;
• Clarify regulatory enforcement authorities of the U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC); and
• Limiting the types of counterparties that can participate in derivative transactions.