October 20, 2008
On Cox’s NYT Credit Default Editorial: Is Disclosure Enough?
Posted by Mike Guttentag

Christopher Cox wrote an editorial yesterday in the New York Times stating the obvious: the credit default swaps market should be regulated.  Cox proposes that Congress enact legislation to bring the traditional tools of the SEC to the credit default swap market, including mandatory disclosure and anti-fraud enforcement. 

What is troubling about Cox’s editorial is that there appears to be little consideration of the distinct problems associated with credit default swaps.  Cox’s proposal is built upon a generic reliance on the efficacy of disclosure requirements, as evidenced by Cox’s allusion to Brandeis’ famous observation that “sunshine is the best of disinfectants.”  But Cox offers no evidence that disclosure requirements (and anti-fraud provisions) will effectively address many of the potentially destabilizing effects of today’s credit default swaps market. 

One of the implications of my ongoing series of posts on the October 1987 market crash is that disclosure requirements alone are unlikely to ameliorate market crashes.  As history has shown, crashes occur even when the sun is shining quite brightly, one of the lessons from the October 1987 crash.  Cox’s suggestion of SEC style regulation may well improve the efficacy of the credit defaults market, and there are sound reasons to believe more complete markets reduce the likelihood of a crash.  However, a thoughtful consideration of how to deal with the systemic risks associated with credit default swaps is missing from the Cox discussion.  Some of the obvious questions about credit default swaps are not discussed.  To what extent are credit default swaps an insurance product? If they are, should they be subject to the same types of solvency regulation imposed on other insurance products?  How similar is Cox’s recommendation that we establish a “financially stable clearance and settlement organization” to the self-regulation approach that he recently admitted failed with respect to maintaining adequate capital reserves at investment banks?

I would encourage the SEC to be more precise about the benefits and limitations of requiring disclosure, so that we can move beyond Brandeis’ argument by analogy that disclosure magically cures all market woes.

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