1). These  market events and the estimated size of the CDS market have raised  concerns about the risks that CDS and similar financial products may pose  to the stability of the financial system. While U.S. federal financial regulators do not have authority over CDS as a  product, in the United Kingdom, which has a CDS market comparable in  size to the U.S. market, FSA has authority over most CDS products. However, its regulatory efforts have generally been pursued in  collaboration with U.S. regulators. Banking regulators’ oversight of CDS activity is largely limited to activity  that is deemed to pose risks to the safety and soundness of the institutions  they regulate. Federal Regulators’ Approach to Monitoring Systemic Risk from CDS Has Hinged on Collaborative Efforts

Federal financial regulators have sought to address potential systemic  threats arising from CDS activities mainly through collaborative efforts  with other supervisors and market participants. However, it is unclear to what  extent the activities of unregulated subsidiaries or other unregulated  market participants were also being reviewed as part of these initiatives. However, some market participants and observers  noted that the current regulatory structure did not enable any one  regulator to monitor all market participants and assess potential systemic  risks from CDS and other types of complex products. Risks and Challenges Presented by CDS and Other Financial Products

Risks to financial institutions and markets from CDS include counterparty  credit risk, operational risk, concentration risk, and jump-to-default risk. More specifically, CDS  referencing ABS and CDOs, particularly those related to mortgages, were  identified as posing greater risks to institutions and markets than other  types of CDS. Regulators and market participants noted that some OTC  derivatives may share similar risks. Equity derivatives specifically were  identified as the OTC derivatives that were most similar to CDS in terms of  the risks and challenges that they presented. CDS Can Also Pose a Number of Other Risks and Challenges

Other risks and challenges from CDS identified by market participants,  observers, and regulators include a lack of transparency in the CDS  market, the potential for manipulation related to the use of CDS as a price  discovery mechanism, and the use of CDS for speculative purposes. However, other regulators and market participants disagree and note that  speculators in the CDS market provide liquidity to the market and  facilitate hedging. Regulators and the Industry Have Undertaken a Number of Initiatives Recently to Address Risks Posed By CDS and Other Financial Products

Financial regulators and the industry have initiated several efforts to begin  addressing some of the most important risks posed by CDS and similar  products, particularly operational and counterparty credit risks. These  efforts include improving the operational infrastructure of CDS markets,  implementing a clearinghouse or central counterparty to clear CDS trades,  and establishing a central trade registry for CDS. If implemented  effectively and sustained, the recent initiatives could begin to address  some of the risks related to the use of CDS. And  second, the efforts would not include the more customized and highly  structured CDS that can include CDS on complex reference entities that  may pose significant risks to institutions and financial markets. These include mandatory clearing or restricting CDS trades. Finally, OTC  derivatives that share some of the risks related to CDS could benefit from  similar efforts to mitigate their impact. However, a  central trade repository that contains information on all CDS trades will  allow regulators to monitor large positions of market participants and  identify large and concentrated positions that may warrant additional  attention. Second,  TIW currently has no regulatory oversight to ensure the quality of the data,  and regulators lack the authority to require that all trades be included in  TIW, particularly those of nonbanks. Bank regulators may have some insights into the activities of their  supervised banks that act as derivatives dealers, but CDS, like OTC  derivatives in general, are not regulated products, and the transactions are  generally not subject to regulation by SEC, CFTC, or any other U.S.  financial regulator.
Why GAO Did This Study

The U.S. financial system is more prone to systemic risk today because (1) the current U.S. financial regulatory system is not designed to adequately oversee today's large and interconnected financial institutions, (2) not all financial activities and institutions fall under the direct purview of financial regulators, and (3) market innovations have led to the creation of new and sometimes complex products that were not envisioned as the current regulatory system developed. Credit default swaps (CDS) are one of the products that have assumed a key role in financial markets. My statement will discuss (1) the extent to which U.S. financial regulators and the UK regulator oversee CDS, (2) risks and challenges that CDS present to the stability of financial markets and institutions and similar concerns that other products may pose, and (3) the recent steps that financial regulators and the industry have taken to address risks pose by CDS and similar efforts that may be warranted for other financial products. GAO reviewed research studies and congressional testimonies. We interviewed financial regulators and a variety of financial market participants. In January 2009, GAO designated the financial regulatory system as a high-risk area in need of congressional attention. Issues involving systemic risk regulation in general and CDS in particular should be considered as part of that effort.

What GAO Found

The current regulatory structure for CDS does not provide any one regulator with authority over all participants in the CDS market, making it difficult to monitor and manage potential systemic risk. Federal oversight of CDS trading and monitoring of the CDS market are largely conducted through the banking regulators' safety and soundness oversight of supervised banks that act as CDS dealers. The Securities and Exchange Commission and the Commodity Futures Trading Commission lack the authority to regulate CDS broadly as financial products. Regulators have sought to address potential systemic risks arising from CDS activities mainly through collaborative efforts with other supervisors and key market participants. However, the extent to which regulators routinely monitor the CDS activity of unregulated market participants is unclear. The Financial Services Authority in the United Kingdom has authority over most CDS products and can collect information about the CDS market, but it has pursued most of its regulatory efforts in collaboration with U.S. regulators. CDS pose a number of risks to institutions and markets, many of which are not unique. These include counterparty credit, operational, concentration, and jump-to-default risks. Market participants and observers noted that CDS referencing asset-backed securities (ABS) and collateralized debt obligations (CDOs), particularly those related to mortgages, currently pose greater risks to institutions and markets than other types of CDS. Other risks and challenges from CDS relate to the lack of transparency in CDS markets, the potential for manipulation related to the use of CDS as a price discovery mechanism, and the use of CDS for speculative purposes. Regulators and market participants noted that over-the-counter (OTC) derivatives, to varying degrees, may pose some similar risks and a few identified equity derivatives as the OTC derivatives that were most similar to CDS. Financial regulators and market participants have initiated several efforts to mitigate these risks. These efforts target primarily operational and counterparty credit risks and include improving the operational infrastructure of CDS markets, creating a clearinghouse or central counterparty process to clear CDS trades, and establishing a central trade registry for CDS. If effectively implemented and sustained, these initiatives couldbegin to address some of the risks noted. But the effectiveness of these recent initiatives could be limited because participation is voluntary and regulators lack the authority to require all market participants to report their trades to a repository. Moreover, customized and highly structured CDS, which can include CDS with complex reference entities that may present additional risks, generally lack the standardization necessary for centralized clearing. Other ideas to reform CDS markets, such as mandatory clearing or limiting some types of trades, have important limitations that would need to be addressed. Finally, many participants and observers agreed that OTC derivatives other than CDS generally share some of the same risks and could benefit from similar efforts to mitigate their impact.