According to many commentators the credit derivatives and especially CDS have been a leading cause to the development of the current financial crisis. During the last year, policy makers, regulators, and other commentators around the world have therefore focused their attention on how to regulate OTC derivatives and especially CDS.
The purpose of this paper is to analyze some of the proposed regulatory responses to OTC derivatives and especially CDS from an economic point of view. The paper proposes a twofold regulatory response. First it proposes that we return to the old common law rule of "rule against difference contracts". The second part of the proposal, which relates especially to CDS, is to simultaneously assist the market participants establish central counterparty trading. This would include collateral requirements, daily mark to market, standardization of CDS, etc.
Building upon the misunderstandings of derivatives and the urge by policy makers to act, it’s easy that the regulatory debate goes out of hand and that misunderstanding about derivatives leads to miss regulation of the same. The risk is therefore apparent that policy makers will overact and over regulate OTC derivatives. This would destroy the undoubtedly positive effect OTC derivatives play for sound risk management in many corporations. The challenge is to find the right balance between over and under regulation. The policy proposal in this paper is a way to strike this tradeoff.
Submitted as a requirement for FN699 "Current Issues in Finance: Financial Crisis and Risk Management", taught by Dr. Lucjan T. Orlowski, Sacred Heart University John F. Welch College of Business, Luxembourg Campus
Welin, Erik, "Regulation of the OTC Derivatives Market: a Regulatory Proposal of CDS" (2009). WCOB Student Papers. 2.