Being Naked - et Quo hinc ?: Developing a ‘Skin-in-the-Game’ Solution for Credit Default Swaps

Shanuka Senarath (), Pelma Rajapakse, Jan Job de Vries Robbé, Naveen Wickremeratne and Maduka Subasinghage
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Shanuka Senarath: Department of Economics, University of Colombo, Colombo 00700, Sri Lanka
Pelma Rajapakse: Department of Accounting, Finance and Economics, Griffith University, 170 Kessels Road, Nathan, QLD 4111, Australia
Jan Job de Vries Robbé: Dutch Development Bank, Anna van Saksenlaan 71, 2509 AB The Hague, The Netherlands
Naveen Wickremeratne: Department of Economics, Monash University, Clayton, VIC 3800, Australia
Maduka Subasinghage: Business Information Systems Department, Auckland University of Technology, Auckland 1010, New Zealand

IJFS, 2022, vol. 10, issue 4, 1-14

Abstract: A credit default swap (CDS) is a derivative financial instrument that provides insurance against credit risk. CDSs on subprime Asset Backed Securities (ABSs) paved the way for securitizers to hedge the credit risk of the underlying subprime loans during the onset of the Global Financial Crisis (GFC). Thus, mortgage originators were least concerned about the quality of loans they securitize since they could hedge the default risk via CDS, paving way to a moral hazard concern. We argue that the core issue pertaining to CDSs, moral hazards, remains unattended even after a decade since the GFC. This paper, utilizing a lexonomic approach embedded in the second-best efficiency criteria, examines the mechanism behind a CDS and develops a regulatory framework with the view of minimizing moral hazards associated with CDSs. Our analysis indicates that incorporating an ‘excess’ on CDSs may minimize moral hazards, since originators are compelled to bear part of the risk associated with assets they create.

Keywords: credit default swaps; global financial crisis; excess; moral hazard; originate-to-distribute (search for similar items in EconPapers)
JEL-codes: F2 F3 F41 F42 G1 G2 G3 (search for similar items in EconPapers)
Date: 2022
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