CDSs and Marking to Market
Unlike insurance, credit default swaps are marked to market. That means the value of the swap reflects the current market value, which can swing sharply and suddenly. Value changes require the sellers to post collateral. Sudden and sharp changes in the credit rating of the issuer of the bonds, or of the bonds themselves, can produce large swings in the value of the swaps, and thus the need to post large and increasing amounts of collateral. That capital strain can produce sudden liquidity problems for sellers. The seller may own enough assets to provide collateral, but the assets may not be liquid, and thus not immediately accessible.
When many sellers are forced to sell assets, the price of those assets falls and sellers are faced with taking large losses just to meet collateral requirements. As the prices of the assets are driven down by forced sales, mark-to-market losses increase, and the collateral posting cycle continues. Meanwhile, the underlying assets may continue to perform, paying interest and principal in full.
Steps to Bring CDSs under Control
On September 22, we announced that New York State would, beginning in January 2009, regulate the insurance part of the credit default swap market, which has, to date, been unregulated—the part which the Insurance Department has jurisdiction to regulate.
That announcement played an important role in spurring national discussion about a comprehensive regulatory structure for the CDS market. The result has been exactly what was envisioned—a broad debate and discussion about the best way to bring controls and oversight to this huge and important market, and concrete progress toward a centralized risk management, trading, and clearing system.
After our announcement, SEC Chairman Cox asked for the power to regulate the credit default swap market. The New York Federal Reserve began a series of meetings with the dealer community to discuss how to proceed. We believe that there are appropriate uses for credit default swaps.
We acknowledge that some amount of speculation can provide useful information and market liquidity. We also recognize that the best route to a healthy market in credit default swaps is not to divide it up among regulators. It would not be effective or efficient for New York to regulate some transactions under the insurance law, while other transactions are either not regulated or regulated under some other law. The best outcome is a holistic solution for the entire credit default swap market.
1 This article is drawn from Dinallo’s testimony to the US Congress on November 20, 2008, at a hearing to review the role of credit derivatives in the US economy.
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