Regulating Credit Default Swaps as Insurance: A Law and Economics Perspective
24 Pages Posted: 23 May 2009
Date Written: May 23, 2009
Much of the debate regarding the current financial crisis revolves around the especially destructive role that credit default swaps (CDSs) had to play. It has become clear that the lax regulatory framework implemented in the latter part of the last century incentivized the very behavior that CDS regulation ought to proscribe. Market participants on both sides of CDS transactions faced incentives to ignore the systemic risk inherent in unchecked CDS transacting. When billions of dollars worth of CDS obligations came due, the financial institutions that issued them failed, which had an enormous impact on the economy as a whole.
In the wake of the current financial crisis, the State of New York has announced plans to subject a large portion of the CDS market to the regulatory oversight of the New York State Insurance Department. Using the Coase Theorem, I explain why this plan is ill advised. Although such a regulatory framework may force market participants to internalize systemic risk, it does not do so at the lowest cost when one properly considers the unique attributes of CDSs and the external pressures that influence state-based regulatory decision-making.
Keywords: Credit default swaps, insurance, regulation, AIG, law and economics
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