The regulatory issues raised by credit default swaps

This article considers the regulatory issues raised by the increased use of credit default swaps (CDSs). It argues that the current extensive over-the-counter trading of CDSs raises problems in terms of the opacity of risk, misaligned incentives in the event of default by reference entities, and concentrations of counterparty risk, each of which requires addressing. Among the proposals discussed are the standardisation of CDSs, the use of central counterparties, the introduction of exchange trading of CDSs, the imposition of capital penalties on bespoke CDSs or mandatory collateralisation, limiting the extent to which CDSs can be used to hedge a position fully, the prohibition of naked CDS protection and the introduction of large exposure counterparty limits. The article concludes that while standardisation and exchange trading of CDSs should be promoted, mandatory collateralisation is preferable to the use of capital penalties. Naked CDS protection buying should be prohibited unless measures can be put in place to ensure that it does not have adverse effects in the event of default by reference entities. Systemic risk in the CDS markets should be addressed through the introduction of large exposure counterparty limits.