The Law and Economics of Credit Default Swaps: Derivatives Regulation, Insurance Law, and Recent Financial Market Reforms

The study investigates the legal and regulatory aspects of credit default swaps (CDSs), a controversial financial transaction that functions as a type of credit risk insurance. Regarding their legal characterization, it is found that CDSs should normally be classified as insurance contracts unless such classification has been specifically excluded by legislation. It is incorrect to treat them as financial securities, because CDSs are strictly bilateral contracts that can be traded in secondary markets only improperly through novations. Despite their name, their classification as swaps does not correspond to the standard financial meaning of swaps. Recent legislation has broadened the category of swaps to include these transactions in some cases, but the outcome is even more confusing in terms of legal doctrine.

Regarding regulatory policy, it is found that the problems created by CDSs should be tackled by a combination of regulatory strategies. At present, the principal regulatory framework is the industry self-governance architecture designed and controlled by the International Swaps and Derivatives Association (ISDA); despite its many weaknesses it also has advantages, which might be harnessed through co-regulation. In terms of transparency regulation, the post-crisis regulatory reforms have moderately reduced the opacity of the CDS market, and increased disclosures would probably fail to address the main problems associated with CDSs. Compulsory central counterparty (CCP) clearing has acquired prominence through the post-crisis regulatory reforms; it is however unlikely to work well for CDSs, which are functionally not swaps but credit insurance, so that their risk profile is asymmetric and involves significant fat tails and macroeconomic correlation.

In the future, the most promising alternative is to apply the principles of credit insurance regulation in a way that addresses the peculiar concerns raised by CDSs. Targeted protection selling limits might be applied within the post-reform regulatory scheme that covers CCPs and compulsory collateral requirements. Targeted protection buying regulation is also an option, and the recent European short selling regulation provides a useful test case that will be studied empirically in order to evaluate its effectiveness and costs.