Sometimes Too Great a Notional: Measuring the 'Systemic Significance' of OTC Credit Derivatives

Abstract

This article proposes several simple financial market reforms that can help regulators both identify systemically risky institutions and mitigate the systemic risk associated with derivative trading, especially trading in credit derivatives such as credit default swaps.

The Federal Reserve (or other systemic risk regulator) should require that financial institutions publicly disclose detailed information on all credit derivatives in their portfolio - including counterparties and notional value - on a frequent basis. The notional value of credit derivatives provides a gauge of the maximum amount the derivative seller must pay the buyer if the underlying credit instrument defaults. Although the notional value is not a good indicator of a derivative’s market value (it is unlikely that each contract in the portfolio would have to be settled for the full notional amount), the notional value of all credit derivatives in an institution’s portfolio is a powerful indicator of the systemic risk posed by that institution’s investments because it is the maximum amount the institution could owe to (or be owed by) other institutions in an extreme event such as the 2008 credit freeze.

The government should use this disclosure to identify which financial institutions are “systemically significant.” Any institution whose credit derivative portfolio has a notional value exceeding a certain threshold for a several days would be regulated for several years as a “Tier 1 Financial Holding Company” per the Administration’s proposal.

Exchange-traded derivatives should not count in the notional value threshold for systemic significance, creating an incentive to move OTC contracts to exchanges.

Keywords: OTC derivatives, credit derivatives, credit default swaps, systemic risk, financial regulation

JEL Classification: G28, K22