Supplementing Dodd-Frank: An Argument for Further Increasing the Regulation of Credit Default Swaps.

• Date: 01 January 2021
• Author: Maharaj, Jessica
• Published date: 22 September 2020
• Author: Maharaj, Jessica

1. INTRODUCTION 247 II. BACKGROUND 248 A. Derivatives 248 B. Credit Default Swaps 249 C. Increased Regulation of CDSs Through the Dodd-Frank Act 251 III. WHERE CURRENT REGULATION OF CDSS STANDS TODAY 253 A. The Dodd-Frank Act and Its Aftermath 253 B. The International Swap Derivatives Association as Self-Regulators 255 C. Where the Dodd-Frank Act Went Wrong 256 IV. RECOMMENDATION 258 A. Limits on Funding Sources for Protection Sellers 258 B. Increasing Regulation of Clearinghouses and Expansion of Authority 259 V. CONCLUSION: CDSS NEED MORE REGULATION BUT NOT AT THE COST OF CUSTOMIZATION 262 I. INTRODUCTION

   Credit Default Swaps have provided protection buyers and protection sellers with customizable financial protection for nearly three decades, all the while operating under a changing regulatory landscape. Credit Default Swaps (CDSs) are highly customizable in nature, allowing a protection buyer to purchase 'protection' from a protection seller in the case of a negative credit event. Then a default payment will be issued, which protects a protection buyer from making a bad investment. CDSs were poorly regulated when they were first introduced over thirty years ago. After the Financial Crisis of 2008, the Dodd-Frank Act was passed and introduced a plethora of new regulations across the entire U.S. financial industry. While Dodd-Frank was a large step in the right direction, it did not completely regulate CDSs. For example, Dodd-Frank did not introduce a protocol for regulating types of CDSs that were not yet in existence when the Act was passed.

   This Note examines the weaknesses of the Dodd-Frank Act in terms of regulating CDSs and suggests ways to more comprehensively regulate CDSs and future developments in CDSs without sacrificing the ability to customize CDSs. First, the Note begins with an overview of derivatives, followed by an overview of Credit Default Swaps. Next, this Note examines the regulation--or rather the lack of regulation--of CDSs before the Financial Crisis and new regulations that came into effect as a result of the role of Credit Default Swaps in the Financial Crisis. Then, this Note examines the weaknesses of the Dodd-Frank Act in terms of regulating CDSs, namely the Act's failure to respond to new developments related to CDSs and its weaknesses related to the establishment of clearinghouses. Lastly, this Note gives recommendations of ways that CDSs can be further regulated without sacrificing their ability to be customized.

2. BACKGROUND

   1. Derivatives

      A typical definition of a derivative is "a financial instrument whose value derives from that of something else." (1) A financial instrument is simply a contract that lays out a financial agreement between two parties. (2) The value of a derivative is derived from its underlier. (3) An underlier "can or must be sold on or before a future date, at a predetermined (guaranteed) price." (4) Underliers can be any traded item, (5) but some traded items are better underliers than others. A better underlier for a derivative is one that is both fungible--which means an asset can be traded for another asset under the understanding both are equally valuable--and liquid--meaning there are many buyers and sellers of an asset at any given time. (6) Examples of sufficient underliers which are both fungible and liquid include: commodities, foreign exchanges, interest rates, and equities such as stocks. (7)

      Derivatives are typically used for hedging or speculation. (8) Hedging and speculating have opposite goals. Hedging involves the mitigation of risk in order to contain any volatility that may occur if the price of a security changes. (9) There is quite a bit of protection against losses with hedging, but gains are also restricted since hedgers take "an opposite position in the market to what they are trying to hedge." (10) Thus, if a negative event happens in the market, that negative event will essentially be canceled out. (11) Speculation involves trying to profit off of an educated guess about market fluctuations. (12) Speculations oftentimes involve purposely taking on additional risk rather than hedging, or decreasing, risk. (13) They involve speed, (14) high risk, and a potentially high return. (15) Speculations are incredibly risky because markets can be volatile and highly unpredictable at times. (16) It is possible to hedge and speculate without using derivatives; however, derivatives have "leverage" in the market. (17) In a derivatives market, this typically means hedgers and speculators can do more with less capital at the outset. (18) For example, buying options in the derivative market can require less capital than buying stocks in the financial market. This allows a speculator to enter the marketplace as a participant with less of a barrier. Similarly, banks can use CDSs to reduce the amount of capital they need to hold in reserve against loans they issued, which leaves money free for banks to use in other ways. (19)

      There are four types of derivatives: a forward contract, a futures contract, a swap contract, and an option contract. (20) A forward contract is an agreement to purchase a financial instrument at an agreed upon price on a specified future date. (21) A futures contract is simply a forward contract fulfilled at an exchange, which is where buyers and sellers come together to conduct transactions. (22) A swap contract is an agreement between parties to exchange the cash flows or liabilities from separate financial instruments. (23) An option contract gives one party the right, but not the obligation, to buy or sell a financial instrument at an agreed upon price, on or before a future date. (24) This paper focuses on a type of swap derivative, called a credit default swap.

   2. Credit Default Swaps

      CDSs are the most popular type of credit derivative. (25) A credit derivative derives its value from an underlier that is the "credit performance of an individual, corporation, government organization, or sovereign entity." (26) A credit default swap involves a party, called the protection buyer and another party, called the protection seller. (27) The protection seller makes an agreement to protect the protection buyer from credit risk by agreeing to pay the protection buyer if a credit event occurs. (28) In exchange, the protection buyer pays premiums to the protection seller. (29) A credit event (30) can be anything the parties agree, including "bankruptcy, a buyout, or a debtor downgrade." (31) Most commonly, a credit event is a debtor default. (32) Since parties can customize what credit risk is involved in their agreement and what credit event would trigger payment, it has been difficult to regulate CDSs in the past because CDSs cannot be regulated with a one-size-fits-all standard. (33)

      CDSs can function like insurance. (34) The protection seller insures the protection buyer against the risk of loss if the credit event occurs, and the protection buyer pays a premium for this so-called insurance. (35) CDSs differ from insurance contracts in several ways. For example, the protection buyer does not own the underlier so "the purchaser of the CDS protection has no real 'insurable interest' to preserve." (36) Due to the lack of regulation of CDSs, the only place they could be bought and sold was in over-the-counter (OTC) markets. (37) Lack of regulation and the nature of the OTC market allowed investors the freedom to speculate with little oversight. (38) Investors were no longer looking for good investments in CDSs, and they were not trying to hedge risk. (39) Instead, they would speculate about how likely it was a credit event would occur. If a credit event did not occur, a protection seller could collect premium payments from protection buyers without ever paying the protection buyer. (40) This allowed protection sellers to agree to CDS contracts without the capital to back up any potential payout to the protection buyer on hand. (41) Protection buyers were also free to purchase bad debt and then use CDSs to protect against risk of loss. (42) If the credit event occurred, the protection seller would have to give the protection buyer money so the protection buyer did not face a loss. (43) Additionally, the number of protection buyers and protection sellers that can create a CDS on the same underlier is unlimited. (44) All of this together led to oversaturation in the CDS market, as well as rampant speculation.

      "Derivatives and CDSs did play a part in the global financial crisis, but they did not cause it," Blyth Masters, Chief Financial Officer of JP Morgan--the same JP Morgan that invented the CDS--announced at a conference by the European Commission in 2009. (45) He was right. The influx of speculation in CDSs contributed to the cause of the Financial Crisis in 2008 but did not cause it. The cause is largely attributed to mortgage-backed securities being used as underlying assets for numerous kinds of transactions. (46) Credit rating agencies gave subprime mortgage-backed securities AAA ratings even though many of them should have received lower ratings or even junk status. (47) When the mortgage bubble burst, homeowners began defaulting on their mortgages in droves, causing the crisis. (48) CDSs had a role in this because financial institutions used CDSs to hedge risk and limit their credit exposure. (49) However, more often, CDSs were used to speculate. (50) CDSs "provided a golden opportunity for bearish investors to bet against the housing boom." (51) When the housing bubble burst, protection sellers--who were in CDS contracts guaranteeing mortgage debts--suddenly had to come up with large amounts of capital to fund payouts to protection buyers. (52) Homeowners were defaulting on their mortgages at a much faster rate than protection sellers could come up with capital for payouts. (53) This led to more and more defaults in other sectors in addition to mortgages. (54) Many protection sellers were unable to come up with...