Financial Engineering Meets Legal Alchemy: Decoding the Mystery of Credit Default Swaps

This Article critically examines the legal nature of credit default swaps. Functionally a form of credit default insurance, CDSs are however commonly characterized as largely unregulated financial derivatives, and were widely blamed for exacerbating the global financial crisis of 2007-09 and contributing to the European debt crisis starting in 2010. This Article demonstrates that the classification of CDSs as derivatives is due to a misapplication of insurance law principles and a glaring misreading of relevant legislation. Furthermore, CDSs are structurally and economically not swaps, which raises suspicions of deliberate evasion of the law by classifying them as swaps. Given the widespread confusion surrounding CDSs, this Article examines the history of the legal concept of swaps and demonstrates that the International Swaps and Derivatives Association developed them in order to exploit regulatory exemptions, which were later extended to an increasing range of deregulated transactions. Additionally, the Dodd-Frank Act reforms, which seek to control the excesses of financial innovation, paradoxically consolidate the regime of largely unregulated swaps. Ongoing legal and policy issues are highlighted.