Credit Derivatives Market: The Eminence of Regulation

A credit derivative is an OTC derivative instrument designed to transfer credit risk from one party to another. By synthetically creating or eliminating credit exposures, they allow institutions to more effectively manage credit risks. It may take many forms like Credit Defaults swaps, Credit Linked Note and Total Return Swaps. This paper reviews prevailing credit derivatives markets regulation and comments on the need to regulate these markets in light of the recent financial crisis. Although credit derivatives may have had beneficial effects such as enhancing the resilience of the financial system,these benefits can only be reaped if credit derivatives are used prudently and responsibly by all market participants. We argue that the current regulatory regime is not sufficient to induce market participants to use credit derivatives in a desirable way. Rather, the existing system, which is mainly based on self-regulatory initiatives, should be accompanied by supervisory action such as the introduction of mandatory disclosure of credit derivative transactions or collateral requirements for all credit derivative transaction counter-parties. The combination of self-regulatory initiatives together with strict supervisory action seems to be well-suited to help preventing market participants from misusing credit derivatives, therewith dampening the dangers these instruments might pose to the stability of the financial system.