Credit derivatives and the Dodd–Frank Act: Is the regulatory response appropriate?

Credit derivatives played an important role in the financial market events of 2008–2009, usually referred to as the ‘Credit Crisis’. The US Congress enacted the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010 as a comprehensive response to the issues identified as causal in the Credit Crisis. Collateralized Debt Obligations and Credit Default Swaps are among the major credit derivatives developed by the financial industry in the recent decades. This article reviews the measures proposed in the Dodd–Frank Act for regulating credit derivatives and questions their adequacy. The Dodd–Frank Act attempts to improve the procedures or mechanics governing the trade in credit derivatives and to promote prudential standards for the entities dealing in swaps. However, it makes no effort to address the speculative character of swap instruments, in particular credit derivatives. The article proposes a screening procedure before the launch of financial instruments, which can help generate an informed debate on the instruments. The procedure can help in better understanding the risks involved and in devising appropriate safeguards.