10 - Credit derivatives market design

Summary

Introduction

Now that the first wave of the financial crisis has been resolved through the coordinated efforts of regulators and banks, it is important to address some of the systematic weaknesses of the current financial system. One such weakness is the inappropriate incentive effects of the market for credit derivatives, and in particular, for credit default swaps. As a risk management tool, credit derivatives were originally an effective means of diversifying lending risk. Credit derivatives have worked to cover exposures where there have been credit events of the underlying reference entities.

However, as products proliferated in number and complexity, they have caused some negative consequences, increasing risk of losses for less sophisticated investors, creating excessive exposures for banks and other entities, and creating negative incentives in respect of financially distressed companies. In part, the risks arose because of the expansion to markets involving asset-backed commercial paper, residential mortgages and other products where some of the underlying assets had been inappropriately valued or rated and thus risk mispriced. In part, these risks arose when derivatives became part of the “originate and distribute” model of lending; and in part, they arose from the speculative market for these products, which has shifted derivatives to some extent from their original risk diversification purposes.