A New Year’s Regulation?

Thank you to Daniel Solove and the other authors for the invitation to join Concurring Opinions as a guest blogger and thanks to Solangel Maldonado for her kind introduction. As Solangel noted, I am teaching and writing in the areas of business associations, corporate governance and securities regulation. In practice, I had the privilege of working on transactions for domestic and international clients. Fortunately, my professional experience has blended naturally with my scholarship, a factor that has eased my recent transition into teaching law.

Traditionally at the start of each year, we outline goals that we try our best to adopt and practice. Considering the recent financial crisis, our focus this year may be more aptly directed to setting out new regulation rather than aspirational resolutions. The financial crisis illustrates several areas that will require a substantial national and international commitment to evaluate market structures and oversight. Credit derivatives, namely the credit default swap industry, played a central role as a precipitating factor in the market’s decline and continuing tumult. Credit default swap agreements or CDS presents one kind of credit derivative contract most simply described as a guarantee contract in which one party (protection buyer) agrees to make periodic payments to another party (protection seller) in exchange for protection against a decline in value of an asset named in the contract. A debt security was usually the underlying asset named in these agreements and counterparties defined a decline in value of the underlying asset as an instance in which the debt issuer defaulted on its principal or interest payment obligations.

A common example evokes images of Happy Hedgers, a hedge fund that owns a General Motors (GM) bond, entering into a CDS agreement which requires them to pay out to, oh, let’s say AIG, a small premium over the 10 year life of the GM bond, but if GM defaults, AIG agrees to pay Happy Hedgers some portion of the value of its loss. By design, these products of financial innovation challenge our fragmented domestic regulatory framework and, as the recent financial crisis illustrates, credit default swap agreements have the potential to exert significant pressure on the global economy. I am intrigued by the innovation that led to the creation of these products and the debate over their regulation. In subsequent posts, I will describe how financial innovation motivated increasingly sophisticated and speculative uses of these products.

In a paper that I anticipate posting to SSRN early this year, I offer reflections on these instruments and a proposal for domestic and international regulatory collaboration to address systemic risk concerns engendered by credit default swaps. I am enthusiastic about sharing my musing with the Concurring Opinion community and welcome feedback.

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