are either notional principal contracts or options for tax purposes,(Peaslee & Nirenberg 2008-07-21:129). but this is not certain. There is a risk of having CDS recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event) (Nirenberg & Kopp 1997:8). And, as noted below, the appropriate treatment for Naked CDS may be entirely different. If a CDS is a notional principal contract, pre-default periodic and nonperiodic payments on the swap are deductible and included in ordinary income. If a payment is a termination payment, or a payment received on a sale of the swap to a third party, however, its tax treatment is an open question. In 2004, the Internal Revenue Service announced that it was studying the characterization of CDS in response to taxpayer confusion. As the outcome of its study, the IRS issued proposed regulations in 2011 specifically classifying CDS as notional principal contracts, and thereby qualifying such termination and sale payments for favorable capital gains tax treatment. These proposed regulations—which are yet to be finalized—have already been subject to criticism at a public hearing held by the IRS in January 2012, as well as in the academic press, insofar as that classification would apply to Naked CDS. The thrust of this criticism is that Naked CDS are indistinguishable from gambling wagers, and thus give rise in all instances to ordinary income, including to hedge fund managers on their so-called carried interests, and that the IRS exceeded its authority with the proposed regulations. This is evidenced by the fact that Congress confirmed that certain derivatives, including CDS, do constitute gambling when, in 2000, to allay industry fears that they were illegal gambling, it exempted them from "any State or local law that prohibits or regulates gaming." While this decriminalized Naked CDS, it did not grant them relief under the federal gambling tax provisions. The accounting treatment of CDS used for hedging may not parallel the economic effects and instead, increase volatility. For example, GAAP generally require that CDS be reported on a mark to market basis. In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at cost, unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can induce