Credit default swaps (CDS) may have amplified – but did not cause – the 2008 financial crisis, concludes a new report from the National Center for Policy Analysis’ Financial Crisis Institute.
“In the period leading up to the financial crisis the advantageous leverage and convenience of CDSs fueled a speculative frenzy,” writes Research Associate Hector Colon. “Dealers on both the buy and sell sides rushed to issue and purchase CDSs written on debt they did not even own.”
In the wake of the crisis, Dodd-Frank instituted new regulations that brought the CDS market closer to an exchange-like format, moving away from the unregulated over-the-counter (OTC) trading previously used by CDSs and some derivatives. While there are benefits to trading in a regulated change, such as liquidity and simplicity of clearing, there are times when the basic risks of trading standardized contracts are too large and clients need more customization.
That’s when nonstandard OTC derivatives come into play, says Colon. To prevent major market shocks form OTC derivatives, reforms should focus on improving risk management and regulatory oversight, and ensuring clearer disclosure of positions to counterparties.
“Derivatives are different from, but often confused with, collateralized debt obligations, or CDOs, the bundled bad mortgages sold as securities by mortgage lenders and others,” explained NCPA Senor Fellow David Grantham.
Colon adds, “Regulators worry about the systemic risk caused by nonstandard OTC derivatives and focus solely on markets and positions, but instead they should ensure financial institutions properly manage and disclose their holistic risks.”
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