The Credit Default Swap market shares some blame, but it isn’t justified to make it the Beltway’s latest scapegoat responsible for the economic meltdown.
There is, however, a need for its regulation and a strong CDS clearinghouse as a direct response to a real and growing danger. One or two more defaults from CDS protection sellers could roil this already fragile market.
The fact that the CDS market continues to function is not proof alone that it is healthy and doesn’t need fixing. Unfortunately, today’s financial crisis can trace its roots back to elevated risk-taking fueled by CDS. The real question is, Would banks have still lost over $1 trillion in the current credit debacle if the CDS market had not existed?
In less than 10 years, this market has grown from a tiny, strictly inter-bank market for hedging credit risk to a highly speculative market with a multitude of counterparties. This growth is understandable, as CDS created a cheaper form of betting on company defaults without requiring sizable cash outlays. Since 1997, this market has grown from under $1 trillion to $60 trillion. Although the way the market uses these products today has changed dramatically, the same unregulated OTC trading structure has remained.