Deregulation of the financial markets has been underway for years. The Bush Administration has pushed this agenda hard, but it's worth keeping in mind that it was President Bill Clinton who signed the Commodities Future Modernization Act of 2000. That law was most notable for overturning the ban on single-stock futures, but it did something else quite significant: it settled a turf war between the Securities and Exchange Commission and the Commodity Futures Trading Commission over the regulation of credit default swaps by putting the market largely out of bounds for both regulators.

Fast forward to 2008, and the country now has a virtually unregulated CDS market that has grown truly enormous, from $144 billion a decade to about $55 trillion of notional value today. Not only is the market unregulated, it is without even a central clearinghouse, making the market opaque even to industry participants with huge amounts at stake. One reason cited for Lehman's cascading effect on the market is the investment bank was a huge CDS player and nobody knew exactly which firms had made trades with Lehman and for what amounts.

Timothy Canova, associate dean and professor of international economic law at Chapman University School of Law, says: "A big part of the problem is that the credit derivatives markets can't be measured. If they'd accepted a degree of government regulation, this mess might have been avoided."

Michael Greenberger, a former director of the CFTC's division of trading and markets and today a professor at the University of Maryland's School of Law, describes the CFTC of today as being "an unbelievably passive regulator and the foremost proponent that markets will self correct. They've fallen off the deep end as far as being a real regulator." As for the SEC, while the regulator was given some anti-fraud authority over CDS, Greenberger describes that authority as a "cynical ploy" since the SEC was given no reporting authority and thus no way to discover fraud.

The unrestrained growth of the CDS market, by allowing companies to mistakenly think they had offset risk, has driven the market to its current perilous position, Greenberger argues. "If the CDS market had been controlled, it would not have expanded willy-nilly. Capital requirements would have strangled [CDS] growth and undercut risk taking across the board."

At the very least, Greenberger says either the Treasury or the SEC should regulate the industry by requiring reporting, clearing of trades, capital adequacy requirements, accounting standards, and anti-fraud measures. Capital adequacy is a particularly serious problem. When Lehman failed, for instance, officials were shocked by how many had taken CDS positions to insure against a Lehman failure. "But do the people who issued the CDS have the capital adequacy to pay off? Nobody knows because they are private contracts."

Rob Claassen, a lawyer with Paul, Hastings, Janofsky & Walker in New York who chairs the firm's structured products and derivatives practice, says that "exposure to undercapitalized companies that have written CDS have caused enormous problems." He points out that offsetting risk is what allowed institutions such as Wachovia to leverage their positions. "If the insurance on it is no good, that's very scary."

Unlike Greenberger, Claassen doesn't propose more regulation, which he says can stifle innovation. Much of the CDS troubles could be solved with a central clearinghouse, he argues. "It would create transparency. It would be AAA rated, capitalized properly, and be on the other side of all credit default swaps. If done properly, it would eliminate counterparty risk."

Until recently, despite cajoling by, among others, the Fed, industry players have dragged their feet. Now, however, several clearing proposals are gaining traction. The CME Group and Citadel Investment Group are preparing to launch a platform, as is the Clearing Corp.

Meanwhile, the case for greater regulatory CDS oversight also appears to be finding traction. New York state has decided to treat CDS as insurance products and thus under its regulatory purview. Even so, only about a fifth of the market would be covered and so the governor of New York has called on the federal government to step in. Indeed, SEC Chairman Christopher Cox himself has called for expanded regulatory authority. "I urge you to provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets," he testified to Congress in September.

Whether he will get that authority remains to be seen. At the same meeting Treasury Secretary Hank Paulson argued for delay. "You can't deal with this immediately," he warned.

But if not now, when?

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