CDS: Are These The Only Financial Instruments That Require Regulation?
During the current market crisis, SEC Chairman Cox has repeatedly called for Congress to give the Commission authority over credit default swaps and investment bank holding companies as discussed here. Credit default swaps – esoteric products that were largely unknown on Main Street until recently – have become one of the culprits of the current market crisis. When Congress considers the Chairman’s request, it should also evaluate if credit default swaps are the only financial instrument which requires additional regulation.
Congress has yet to act on the Chairman’s request. Last week however, the SEC took an important step toward adding transparency and structure to the multi-billion dollar CDS market. The Commission, in consultation with the Board of Governors of the Federal Reserve, the New York Fed, the CFTC and the U.K. Financial Services Authority, issued orders which will facilitate the creation of a central counterparty for the CDS market.
Previously, credit default swaps – essentially a bilateral contract between two parties called counterparties – were traded in the over-the-counter markets. The seller of the contract, which is valued based on the underlying instrument, is at risk for significant sums if there is a default. This created huge risks for the economy. Yet, there is little transparency and, until recently, the risks were largely unknown. Insurance giant AIG, a significant player in this market, is emblematic of the potential impact of defaults in this shadowy market. Absent billions in government loans, this “too-big-to-fail” company would have collapsed and taken a large chunk of the economy with it. The creation of a central counterparty should add stability, transparency and a degree of oversight to this huge market.
The actions taken by the Commission are a good first step. At the same time, they only serve to highlight the task before Congress and regulators such as the SEC. Previously, Congress severely constricted the authority of the SEC in this area as part of a years’ long deregulatory trend. Section 206A of the Gramm-Leach-Bliley Act, which added Section 3A to the Exchange Act, essentially precludes the SEC from acting in this huge market. Specifically, Section 206A of the Act excludes from the definition of “security” both non-security-based and security-based swap agreements. GLB is also the Act which completed the abolition of the Glass Stiegel Act and the wall between investment and commercial banks erected in the wake of the last great market crash in the 1930s.
As Congress considers the request of Chairman Cox regarding credit default swaps, it should also evaluate its own years’ long deregulatory actions and look carefully at other unregulated financial instruments. The real question here is not just the CDS market, but whether there are other unregulated or insufficiently regulated instruments which could potentially put the economy at risk. This requires an evaluation not just of what has already happened, but a forward view to the future to adequately empower regulators for the new products Wall Street will undoubtedly bring to market in years to come.
In evaluating this issue, it is important that any new regulation carefully balance the need for transparency, disclosure, supervision and record keeping to facilitate supervision with the necessity to not impede important business arrangements. If Congress and the regulators focus not just on CDS, but other financial instruments and look to the future, their efforts may just help avoid a repetition of the current crisis.