By Gary Gensler
The market for credit default swaps has grown exponentially within the last decade. According to the International Swaps and Derivatives Association’s historical survey of the size of the CDS market, the marketplace grew from a notional value of around $630 billion in the second half of 2001 to $36 trillion by the end of last year. That’s equivalent to roughly two and a half times the amount of goods and services sold in the American economy annually. Bank for International Settlements data indicates that more than 95 percent of credit default swap transactions are between financial institutions.

The 2008 financial crisis had many chapters, but credit default swaps played a lead role throughout the story. They were at the core of the $180 billion bailout of AIG. The reliance on CDS, enabled by the Basel II capital accords, allowed many banks to lower regulatory capital requirements to what proved to be dangerously low levels. They also contributed to weak underwriting standards, particularly for asset securitizations, when investors and Wall Street allowed CDS to stand in for prudent credit analysis.

Credit default swaps have many characteristics similar to other over-the-counter derivatives. They are used to hedge risk, and their value is based on a reference entity. They also have characteristics that distinguish them from other derivatives.

While the value of interest rate or commodity derivatives generally adjusts continuously based on the price of a referenced asset or rate, credit default swaps operate more like binary options. A seller of CDS could one month collect its regular premium with little expectation that the insured company may default and in the next month be on the hookfor billions if the insured company goes bankrupt. A credit default swap can quickly turn from a consistent revenue generator into ruinous costs for the seller of protection. This “jump-to-default” payout structure makes it more difficult to manage the risk of credit default swaps. Credit default swaps also have characteristics similar to bond insurance issued by mono-line insurance providers. Further, credit default swaps based upon a single company relate directly to that company’s capital formation and to the price of their equities, bonds and other securities.

Over-the-Counter Derivatives Reform
Credit default swaps have unique characteristics and played a central role in the financial crisis, but we also must bring comprehensive reform to the rest of the over-the-counter derivatives marketplace. The recent chill winds blowing through Europe, including the discovery that derivatives were used to help mask Greece’s fiscal health, are reminders of the pressing need for comprehensive regulation. The 2008 financial crisis demonstrated how over-the-counter derivatives – initially developed to help manage and lower risk – can actually concentrate and heighten risk in the economy.



A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, no matter where traded or marketed. It should include interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future. Effective reform of the marketplace requires three critical components:

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, Wall Street and the Federal Government had no price reference for particular assets – assets that we began to call “toxic.” Financial reform will be incomplete if we do not achieve public market transparency.

Third, to lower risk further, standard OTC derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. With their use, transactions with counterparties can be moved off the books of financial institutions that may have become both “too big to fail” and “too interconnected to fail.” Centralized clearing has helped to lower risk in futures markets for more than a century.

Regulation of Credit Default Swaps
Regulating derivatives dealers and requiring transparent trading and central clearing of standardized derivatives would greatly reduce risk in the credit default swap market. Additional reforms, however, should be considered to address the unique characteristics of the products. The CFTC is very fortunate to have a strong working relationship with the Securities and Exchange Commission (SEC). Under the Administration’s regulatory reform proposal, both agencies have a role to play, consistent with longstanding precedent, in regulating the CDS markets. The SEC would take the lead on single-issuer and narrow-based CDS, and the CFTC would take the lead on broad-based products. While the views expressed in this speech are my own, we are closely consulting with the SEC on appropriate regulatory reform of credit default swaps and the broader over-the-counter marketplace.

Market Manipulation
The CFTC and the SEC should have clear authority to police the over-the-counter derivatives markets for fraud, manipulation and other abuses. It is important that these markets serve to help people hedge risk as well as provide for efficient and transparent price discovery markets.

At the height of the crisis in the fall of 2008, stock prices, particularly of financial companies, were in a free fall. Some observers believe that CDS figured into that decline. They contend that, as buyers of credit default swaps had an incentive to see a company fail, they may have engaged in market activity to help undermine an underlying company’s prospects. This analysis has led some observers to suggest that credit default swap trading should be restricted or even prohibited when the protection buyer does not have an underlying interest.

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