A Study on the Market Trading and Regulations of Credit Derivatives
Date Issued
2010
Date
2010
Author(s)
Lo, Shu-Wen
Abstract
The history of credit derivatives can be traced back to as early as the 1990s. At the outset of the 21st century, the credit derivatives market flourished as a result of the policy of encouraging financial innovation and the absence of stringent regulations. At that time, all derivatives transactions were conducted in accordance with the rules and protocols of international associations, which were dominated by major market players.
Credit derivatives, which were created to diffuse credit risks, include credit default swaps, total return swaps, credit spread products, collateralized debt obligations and credit-linked notes. One type of credit derivatives may, in a single or multiple layers, be embedded in the same or other types of derivatives to create complex financial products. This article addresses the motives behind the transactions and the trading conditions on the over-the-counter (OTC) and listed markets.
Most credit derivatives transactions are conducted on the OTC market rather than the listed market. OTC transactions are characterized by the agreement between the parties to each transaction. As a result, the public is unaware of the terms and conditions of each transaction or the actual market condition. The 2008 financial crisis triggered the necessity of tightening the regulations on credit derivatives market in order to overcome the drawbacks of low transparency, asymmetric information, credit risks and poor quality of credit rating data.
In 2009, the United States (US) amended the Securities Exchange Act of 1934, thereby requiring credit rating agencies to disclose to investors material and complete information on the procedures and methodologies for valuating structured financial products. In addition, temporary regulations were announced in order to encourage investors to trade through the central counterparties thereby reducing the counterparties’ default risk and facilitating the transparency of trading information. On July 21, 2010, the US president signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), which is the first piece of legislation that regulates OTC derivatives transactions, and imposes further restrictions on credit rating agencies and asset-backed securities. It remains to be seen as to whether the Act could help to resolve the above-mentioned drawbacks of credit derivatives transactions and facilitate financial innovation simultaneously. As the new laws may affect the profit margins of traders, it is critical to identify ways to convince traders to disclose relevant trading information via the new trading system. This article explains the new legislations and explores their potential impact on the market.
Subjects
American Insurance Group, Inc. (AIG)
Credit Default Swaps (CDS)
Collateral Debt Obligations (CDO)
Credit Derivatives
Credit Rating Institutions
Central Counterparties
Risk Management
Contract Interpretation
Insider Trading
Dodd-Frank Wall Street Reform and Consumer Protection Act
Type
thesis
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