What risks and challenges do credit default swaps pose to the stability of financial markets?

O. Williams Brown

Financial Stability Review, 2010, issue 14, 137-142

Abstract: Credit default swaps (CDSs) pose a number of risks to institutions and markets, many of which are not unique. These risks include counterparty credit, operational, concentration, and jump-to-default risks. CDSs also pose other risks and challenges. For example, CDS markets generally lacked transparency, which may have compounded market uncertainty about participants’ overall risk exposures, the concentration of exposures, and the market value of contracts during the recent crisis. Further, regulators note that the potential existed for market participants to manipulate certain CDS prices to profi t in other markets that CDS prices might infl uence, such as the equity market, and that the lack of transparency could contribute to this risk. Others also raised concerns about the use of CDSs for speculative purposes, including concerns about uncovered or “naked” CDS positions – the use of CDSs for speculative purposes when a party to a CDS contract does not own the underlying reference entity or obligation. While regulators and market participants note that over-the-counter (OTC) derivatives, to varying degrees, pose some similar risks, particularly equity derivatives, the US regulatory structure for CDSs does not provide any one regulator with authority over all participants in the CDS market, thereby making monitoring and managing potential systemic risk diffi cult.

Date: 2010
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