By James Hamilton, J.D., LL.M.
In anticipation of the upcoming London Summit, a report by the Center for Economic Policy Research urged the G20 to implement a number of structural market reforms, including a requirement that credit default swaps be exchange-traded and that naked credit default swaps that do not insure the underlying asset be banned. The G20 should also require that credit rating agencies be paid by investors rather than by issuers, or at least sever the link between rating agencies and the issuer so that a rating does not affect the rating agency’s future business with a given client. Also, for asset-backed securitized instruments, there must be greater disclosure of information about the underlying pool of securities. The Center for Economic Policy Research is a network of over 700 research fellows and affiliates, based primarily in European universities.
The center also called on the G20 to prohibit indirect payments by issuers to rating agencies in the form of the purchase of consulting or pre-rating services. The center asked the G20 to consider an open access, non-prescriptive approach by regulators, eliminating the NRSRO designation and the extensive hard wiring of the rating agencies in the regulatory system.
The report identified the concentration of counterparty risk as a major problem. Some financial institutions, such as Lehman Bros or AIG, were able to build up enormous risk positions hidden from the eyes of regulators and their own shareholders. Efficient transfer of risk requires that they be transferred in a diversified way, said the report, held in reasonable proportions within diversified portfolios and in institutions able to absorb losses. This was clearly not the case. In practice, noted the report, the main function of the credit derivative market was to allow institutions to engage in regulatory arbitrage.
In addition, the development of an active market for credit default swaps led to a complicated chain of linked exposures, as an institution may hedge one counterparty risk with another credit default swap. This complexity makes it impossible for a market participant to assess risk. Also, the legal status of the netted positions in case of default of one of the counterparties is unclear. The resulting uncertainty about banks’ positions in the credit derivative market contributed to the disturbances in inter-bank markets. Ironically, while the function of a credit default swap is to reduce risk, the overall impact of these instruments has been to increase systemic risk. Because of the opacity of the credit derivative markets, neither market discipline nor regulators could control the extent of risk.
The group recommended that credit default swap trades be forced to go through an organized transparent market with a centralized clearing counterparty. Moreover, the centralized
clearing counterparty would have to be subject to an implicit government guarantee. Transparency over exposures would allow market discipline and regulators to penalize the excessive concentration of exposures.