Credit derivatives are high on the list of targets for financial reform (some legal scholars were 10 years ahead of the curve on this). But not all credit derivatives are the same. One distinction -- based on whether a derivative is insuring an existing credit risk or not -- is particularly critical.

Lynn Stout has criticized the lack of regulation for credit derivatives and other OTC derivatives in which neither party is hedging an underlying risk. She points out that these pure bets were generally unenforceable contracts until very recently. It is hard to see what the social value of this form of credit derivatives is. It is also hard to see the social cost is, except for creating unexpected counterparty risk (the risk that one of the parties to the derivative contract will default on its obligations). That is a pretty big "except."

Margaret Blair and I written on the second kind of credit derivative, in which at least one of the party is offloading credit risk. In that case, the potential problem is not just unexpected counterparty risk, but the fact that the credit derivatives may increase leverage and inject greater liquidity into the entire financial system. Consider that the party "insuring" credit risk (the credit protection seller) does not have to put all of the money upfront to cover its obligations. This is textbook leverage. On the other hand, the credit protection buyer can offload its credit risk and then lend more money or purchase more asset-back securities. Credit derivatives thus served a valuable role in the shadow banking system, of providing liquidity to markets, extending additional credit, increasing leverage, and, effectively, increasing the money supply. All of which helped fuel the market for asset-backed securities and ultimately the real estate market. Note that the credit derivatives where there is no insurable interest don't pose this particular problem; because no credit risk is being offloaded, those pure bets are not linked to the shadow banking system.

This same binary distinction between types of the credit derivatives also applies to hedge funds. The real problem with hedge funds in the crisis is not that they collapsed en masse (counterparty risk), but that they served a valuable role in the shadow banking system; lacking capital/leverage requirements, they were free to purchase asset-backed securities and enter into credit derivatives. This increased the amount of credit/leverage/liquidity in the entire system. Which can fuel an asset boom, which leads to my next post . . .

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