A critical evaluation of the European credit default swap reform: Its challenges and adverse effects as a result of insufficient assumptions

An understanding of Over-The-Counter (OTC) derivatives – particularly Credit Default Swaps (CDSs) – is essential, because these derivatives are often accused of being toxic and a significant contributor to the financial turmoil of 2008, and therefore also indirectly causing the sickly world economic growth experienced since. This is the position embraced by high-level politicians at G20, in the EU and in the United States; therefore, an overhaul of the OTC derivatives – including the CDS market – appears inevitable. Nonetheless, this article questions this perception of CDSs as an exclusive detrimental product and argues that, although problems of concentration and interconnectedness in the opaque CDS market arguably amplified the crisis, CDSs merely reflected the crash of the US mortgage market. If this is not recognised by politicians and regulators, the likelihood of incomplete reforms causing unintended consequences seems inescapable. This scenario already seems to be playing out in Europe and also potentially in the United States, although an analysis of the US reform is beyond the scope of this article. This conclusion is reached by evaluating three proposals by the European Commission: the European Market Infrastructure Regulation, the Market in Financial Instruments Directive and the Capital Requirement Directive. In short, they intend to mandate or heavily incentivise the trading of CDSs through Central Counterparties (CCPs) and exchanges; enhance OTC-traded CDSs’ capital requirements; and require trades to be reported to designated trade repositories. Although these proposals are well intentioned, the unintended consequences could be considerable, particularly with regard to the extent to which credit risk hedging is possible through CDSs owing to potential prohibitive OTC capital, CCP and exchange-trading requirements. Rather, it is suggested that the reform could be detrimental to its inherent purpose, financial stability, as a concentration of credit risk can accumulate in CDS CCPs. Juxtapose market participants’ ability to hedge credit risk in the regular OTC market is diminished, thus positioning CDSs in a diminishing vacuum between the OTC and exchange traded market. In a worst case scenario, this would undermine the liquidity of the CDS market and make credit risk hedging significantly more difficult and expensive for end-users and ultimately society, at the same time as crucial information on entities creditworthiness deteriorates.