The lack of transparency into the $58 billion Credit default swaps market, which today remains virtually unregulated, poses a high degree of systemic risk to the global financial system. It is characterized by the inability of regulators to: monitor CDS exposure amongst market participants, and the resulting ability to quantify the impact of certain negative events (e.g., credit rating downgrades) on sellers of CDS; and establish standards for capital adequacy and liquidity to provide some measure of stability in the financial system.
The absence of regulatory oversight has significantly reduced transparency into the impact of CDS positions on the overall financial markets and its participants. Currently, the financial markets do not have a mechanism to evaluate the overall exposure to CDS contracts.
On a more fundamental level, buyers of CDS contracts cannot assess the financial strength of a seller, thus at the point of sale it is unclear whether the seller will have the wherewithal to honor its contractual obligations. During the current credit crisis, the collateral covenants in the CDS agreements were triggered and buyers (and the financial system generally) did not know whether the market was on solid footing or the verge of a crisis.
Without an exchange or equivalent mechanism to provide trading and pricing efficiency and protection to the marketplace, 'circuit breakers' could not be 'tripped' or implemented to stem the tide of losses. Additionally, the systemic impact could not be quantified and other measures to protect the integrity of the markets and its participants could not occur. Consequently the Securities and Exchange Commission is setting the stage for some level of regulation of the CDS market to address the financial crisis and has asked Congress for explicit authority to regulate the market.
While final regulation has not yet been developed, it is possible to speculate how the CDS landscape will look once the regulation is known. More stringent collateral and capital adequacy requirements may be the first step, followed by restrictions on naked CDS strategies. A less restrictive approach may require sellers to report to regulator(s) their exposure to "covered" and "naked" CDS transactions and the corresponding collateral assigned to support their obligations to the CDS buyers.
We expect that regulation will force the industry to rethink how CDS transactions occur. Today CDS contracts are primarily written by insurance companies and other financial intermediaries and the buyers are typically the originators and/or the holders of debt products (such as mortgages) and private investment funds. Regulation might serve as a catalyst for the creation of an exchange or equivalent reporting mechanism, which will provide the protections of central clearing and capital adequacy and collateral rules governing market participants. If an exchange is formed for these products, firms would then be required to implement appropriate IT solutions, and to update their operational processes, governance and compliance programs in accordance with the new regulations.
Recent regulatory frameworks that have been introduced include SEC rules 38a-1 and 206(4)-7, which required investment companies and investment advisors to implement comprehensive governance and compliance programs. Shortly after the SEC introduced the aforementioned rules, FINRA (previously NASD) introduced rules 3012 and 3013, requiring similar governance and compliance programs to be adopted by broker dealers. Both require firms to implement solutions to comply with the requirements within one year of adoption.
As we have learned during this financial crisis, opaque and unbridled free markets can create significant systemic risk to the financial system. This highlights the importance of regulation to enforce the proper governance and oversight of financial products, beginning with thoughtful and appropriate government oversight and ultimately placing accountability with Boards of Directors and Chief Executive Officers. Through regulatory intervention, CDS contracts will serve the lending community with needed risk mitigation, without the unintended consequences experienced during the current financial crisis.