You’ve hinted at the real first rule of regulation, Paul: The need for regulation is inversely related to the level of transparency in the market. The more transparency you have, the less regulation you need.
But I’m with Jim on the need for some regulation, and I want to comment particularly on your point about favoring naked CDS contracts.
First, I hope we can all agree that there needs to be a lot more transparency in this market. You never really knew what kind of exposure companies had in the CDS market. That lack of transparency allowed individual companies to take on more risk than the market might otherwise have allowed—vis AIG, which had $400 billion in CDS exposure.
But more broadly, why shouldn’t we ban naked CDS? The risk of such contracts is obvious; they essentially leverage the impact of debt failures. They seem custom-designed to create a domino effect, and to exacerbate the boom and bust cycle of the economy.
Shouldn’t we stop that? Shouldn’t we either ban naked CDS contracts, or, alternatively, regulate them like insurance and require them to be backed by sufficient pools of capital?
Regular CDS contracts have a clear value. CDS contracts backed by walled-off capital make all the sense in the world.
But naked CDS contracts? Why leverage up the impact of failure?