Thursday, March 11, 2010

Counterparty Regulation and its Limits: The Evolution of the CDS Market

By Houman B. Shadab, New York Law School

Abstract: Over-the-counter (OTC) derivatives are widely regarded as “unregulated” financial instruments. While it is true that OTC derivatives are subject to relatively minimal federal regulation, OTC derivatives are in fact subject to a robust form of control and governance in the form of counterparty regulation. Counterparty regulation arises when two or more parties are continually exposed to counterparty credit risk for the duration of a long-term contract, and it consists of specific governance mechanisms such as the daily adjustment of collateral and the netting out of redundant trades. Counterparty regulation governs derivatives transactions but not securities transactions.

This essay reviews recent significant developments in the market for one type of OTC derivatives contract in particular—the market for credit default swaps (CDSs)—and suggests that these developments illustrate the strengths and limitations of counterparty regulation. Given the overall strength of CDS counterparty regulation during the financial crisis, and cooperative efforts being undertaken by CDS market participants and regulators to improve CDS market infrastructure, wide-ranging regulation of CDSs does not seem necessary to achieve greater transparency and financial stability.

Download the paper here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1560184

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