October 19, 2008
Op-Ed Contributor
Swapping Secrecy for Transparency

THE historic volatility in the financial markets has raised important questions about the lack of meaningful regulation of financial instruments known as credit-default swaps. The $85 billion government rescue last month of the insurance conglomerate American International Group, for example, was needed in large part to protect those who held A.I.G.’s credit-default swaps and risked crushing losses if those instruments weren’t honored.

A.I.G. had issued $440 billion in credit-default swaps — which are like insurance contracts on bonds and other assets that are meant to pay off if those assets default. But as markdowns on A.I.G.’s investments in subprime mortgages led to downgrades in its credit ratings, the holders of the credit-default swaps demanded more collateral, which A.I.G. could not provide.

As large as A.I.G.’s swaps exposure was, it represented only 0.8 percent of the $55 trillion in credit-default swaps outstanding — this total market is more than the gross domestic product of all nations on earth combined.

Yet despite its enormous size, the credit-default swaps market has operated in the shadows. There is no public disclosure nor any legal requirement for these contracts to be reported to the Securities and Exchange Commission or any other agency. So government regulators have had no way to assess how much risk is in the system, whether credit-default swaps have been accurately valued or honestly traded, and when people issuing and trading them have taken on risk that threatens others.

Because these instruments have been bought and sold widely and in many cases anonymously, they have trapped the large financial institutions in a web of transactions. This has created systemic risk that is particularly serious in the current stressful economic environment, contributing to a gravitational pull that stands to drag everyone down.

All investors — from individuals through their 401(k) plans to pension funds and asset managers — are paying a price today for the lack of oversight. We must urgently address the problems created by this unregulated environment.

Credit-default swaps are not inherently good or evil. They play an important role in the smooth functioning of capital markets by allowing a broad range of institutional investors to manage the credit risks to which they are exposed. They are also a useful means for investors to signal their view of an entity’s business prospects and creditworthiness.

But our markets function best when they are highly transparent, when everyone can see exactly which transactions are occurring and what the instruments being traded are worth. This gives investors confidence that they can accurately assess risk.

Back in 2000, Congress specifically decided not to regulate credit-default swaps. At that time, this market was just a few years old and still very small. For example, in 1999 a report by the President’s Working Group on Financial Markets envisioned no systemic risk from such derivatives since “private counterparty discipline