In his WSJ article of October 22, Stanford Business School Professor Darrell Duffie sums up the problem with derivatives and proposes a regulatory solution: "[w]hen unconstrained by good regulation, derivatives can be financial weapons of mass destruction. Our new regulations should be smart and surgical."
The smart regulatory scheme that Duffie has proposed focuses on centralized clearing for credit default swaps and other derivatives that are presently traded over-the-counter. Credit default swaps function as insurance policies for debt securities: the party long the swap pays a premium to the counterparty short the swap. If the borrower (i.e. the issuer of the debt securities) defaults, then the swap seller must make payments to its counterparty. AIG cratered largely because it was overexposed to credit risks, having written more insurance policies (i.e. sold more swaps) than it could handle in a volatile credit environment. In the absence of centralized clearing, not only was AIG overexposed to risk but its exposure was non-transparent prior to its failure.
In the futures industry, clearing houses such as the Chicago Mercantile Exchange impose strict capital and margin requirements upon clearing firms and traders to ensure that contract parties meet their financial obligations. Similarly, a well-regulated derivatives clearing house could prevent contract parties, such as credit default swap sellers, from taking on more risk than they can handle -- which would help to prevent another AIG or Long Term Capital Management fiasco.
Posted by Paul Malmfeldt on October 22, 2008
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