I have been reading the Department of the Treasury’s Blueprint for a Modernized Financial Regulatory Structure. Much of it is sensible, and the focus on rationalizing the current hodgepodge of regulation and granting the Fed increased regulatory powers over firms other than commercial banks that create credit.
I want to make a modest proposal that I hope readers who are more economically sophisticated than I am can flesh out or shoot down, as appropriate. The notional value of all of the credit default swaps floating around out there is more than forty trillion (with a “t”) dollars. The basic purpose of a credit default swap is to hedge, or insure, against the risk that some firm will suffer a default or other problem with its credit. So, for example, if I am a bond investor, I might buy a swap from a third party to protect against the risk of nonpayment. The amount I pay is like an insurance premium. But the value of the swaps dwarfs the amount of the risk insured. This is because speculators with no risk to hedge against use swaps to bet on the credit of firms that issue bonds. The huge notional value of the swaps is one of the reasons why the failure of a big player in the derivatives market (so-called “counterparty risk”) would be so disastrous.
So here is my proposal: just as in the insurance market, why not require an “insurable interest” as a prerequisite to buying a credit default swap? To make the idea intuitive, I can buy life insurance on my own life, or my wife’s life, but not on the Queen of England’s life. I can insure my house against fire, but not your house against fire (unless I hold the mortgage on your house or the like). The “insurable interest” rule serves to dampen speculative froth in the insurance market. A similar rule would have the same effect in the derivatives market by confining swaps to their original purpose, namely, hedging against risk.