Financial Derivatives: A Perceived Value

RUNNING HEADER: FINANCIAL DERIVATIVES: A PERCEIVED VALUE
Financial Derivatives: A Perceived Value

Ivan N. Mendes
Eastern Nazarene College

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Abstract
The usage of financial credit derivatives has allowed for increased competition, profitability and systemic
risk in todays financial markets, globally and domestically. These instruments if adequately used may
curb their negative externalities, while allowing positive externalities to flourish. This documentation
looks at the nature of credit derivatives, especially credit default swaps (CDS), collateral debt obligations
(CDO), special purpose vehicles (SPV), and systemic risks and accompanying policies. A brief outlook of
the 2008 global financial crisis is detailed, but the majority of this documentation will be focused on the
purposes, operations, and contractual engineering of CDSs and CDOs. Capped by regulatory policies
following the global financial crisis, this documentation concludes with the Dodd-Frank Act. This
documentation shows the neutrality of credit derivatives, the benefits thereof, and the consequences if
firms are not adequately measuring potential risk factors when contracting derivatives.
Keywords: derivatives, credit derivatives, CDS, CDO, SPV, Dodd-Frank Act, global financial
crisis, market regulation, systemic risk

Derivatives have been in use, for commercial and investment purposes, for centuries, and they are
not new. Once used for bets on the future prices of agricultural commodities, such as rice and corn traded
in 15th century Japan, derivatives have evolved to include any and everything. Today these commodities
are traded on the Chicago Mercantile Exchange, which still involve derivative usage. A derivative is a bet
either used in hedging or speculating. By 1990s, a mass explosion in other forms of derivatives (apart
from agricultural commodities) was on the verge with the introduction of both interest rate swaps, and
credit default swaps. By 1996 the notional value of the credit derivatives market, which is the value of
outstanding bets measured by the value of things being betted on, was roughly $180 billion. In contrast,
the year 2008 saw an estimated notional value of the derivative market of $600 trillioni. Ending June
2013, the notional value of the derivatives market was $668 trillion; this number was reported from
dealers across 13 countriesii. This vast increase in the notional value of the derivatives market can be
attributed to the legal status of speculative trading rather than innovative advancements. Lynn Stout
(2009) speculated that difference contracts made the difference when considering the legality of a
derivative contract, whether it was binding or not. A difference contract states that one may wager on
anything, but the rule required that if one wanted to enforce such a wager he or she had to demonstrate to
a judge that one party held title to the underlying bet. The betted entity is called, in financial derivative
terms, the underlying. Henceforth, bets on every financial instrument possible became available to
savvy investors, whom used the advantage promulgated by swaps to profit (Stout 1009). Credit
derivatives, being traded over-the-counter (OTC), were rarely regulated, causing the old common-law
principles, including difference contracts, to become the primary checks against speculations. Speculation
is the attempt to profit not from producing or even providing investment funds to another who is
producing something but rather from predicting the future better than others. In retrospect, betting on
future events, whether related or unrelated to ones investments. Although the notional value of credit
derivatives was in the trillions of dollars, the market value of these contracts only amassed to $3.9 trillion
at end-June 2013iii. This disparity between market value and notional value questions the amount of
speculation believed to have occurred during the global financial crisis and even now. These numbers

greatly support the ideology that speculative trading still occurs today. Unregulated, the global markets
would take a turn for the worst. Few knew of the implications that such regulations had on the limitedness
of corporate governance and financial power. When Congress repealed the Glass-Stiegel Act (the Act)
in 1999; that same act that was adopted during the crisis of the Great Depression in order to separate
commercial and investment banking activities. It allowed for the merger of the two long separated
entities. In the 1980s, the popularity of laissez-faire regulations began the deregulation reflected in the
U.S. economy until the housing market collapse in 2008-2009. Under the act, commercial banks could not
function as investment banks and underwrite corporate securities (bonds, stocks, options, derivatives) or
engage in brokerage activities. With that said, commercial banks found themselves at a disadvantage,
because the majority of money was being made in investment firms. When Congress repealed GlassStiegel, it enacted the Financial Services Modernization Act of 1999, and its that passage, the
functionality of commercial and investment banks were blurred. As a result of grand deregulation came
the global financial crisis. It is believed that various variables caused the global crisis, such as: high
corporate leverages, over-borrowing, deregulations, securitization, and complex securities. The focus of
this documentation will not be to examine the financial crisis itself, but to examine a key contributor to
the global financial crisis. The key contributor was known as credit derivatives (a complex security).
From its inception, credit derivatives allowed for corporations to provide high leverages with little risk,
thus producing a vast increase in profitability and cash-flow. A credit derivative is simply an investment
vehicle that derived its value from another financial instrument. It is through the introduction of credit
derivatives that the market, inevitably, plummeted to record lows, and the global market, well, shaken to
its core.
CREDIT DEFAULT SWAPS & COLLATERALIZED DEBT OBLIGATIONS
Credit derivatives are mainly used in credit risk management with the purpose of diversifying
across different sectors and geographical regions, or to bypass regulatory constraints. A credit default
swap (CDS) is simply an insurance contract against the cost of default of a company, particularly a

company that has issued debt. This company is referred to as the reference entity. The CDS insures the
protection-buyer payment in a credit event such as a default, or restructuring of debt from the
protection-seller, usually a firm more capable of managing such debts. In essence, a firm is hedging
against a risk if involved in a swap transaction. Regarding a credit event, the protection-seller
(counterparty) would provide payment in the form of a lump sum and return the loan that functioned as
collateral. For this risk, protection-sellers usually required a premium fee to be paid periodically for such
services. For example take Cincinnati based, Gibson Greetings, and Bankers Trust, derivatives contract
which worked like so: Gibson would pay Bankers Trust the six-month LIBOR, squared, then divided by 6
percent times $30 million for four years. In the event of a credit event, Bankers Trust would pay a
minimal payout of 5.50 percent times $30 million.iv When all was said and done, Gibson Greetings lost
more on the premiums paid to Bankers Trust compared to the fulfillment of the contract in a default. It is
because of these reasons that firms such as AIG and Bankers Trust contracted CDS on the hundreds of
collateralized debt obligations (CDO) they managed. In the event that there is not a default, the
protection-seller is not obligated to payout. With that said, unlike other credit derivatives (such as interest
rate swaps), CDS risk assumptions are not symmetrical. The protection-buyer, in essence, takes a short
position in the credit risk of the reference entity (debt-issuing firm), and by this the buyer is relieved of
exposure to default. Ultimately, by doing so the buyer surrenders the ability to profit on the respective
loan, because it is now in the possession of the protection-seller. But still, the protection-buyer is not
completely relieved of risk because it must now be conscience of the default-risk of the protection-seller,
in that it may not be able to payout if the reference entity defaults. This risk is known as the counter-party
reference risk. In addition, the protection-buyer must likewise assume other risks in relation to the
reference entity. In contrast, the protection-seller, ultimately, takes a long position in the credit risk of the
reference entity. Likewise, a counterparty risk is associated with the seller of insurance in regards to
premium revenue, in the event that the protection buyer defaults, which would annul the contract. In its
simplest form, a reference entity is usually a company or government enterprise, and it is in this market
that most CDS contracts are involved. Another form would be that of a basket CDS which is when two or

more reference entities exist. According to Ayadi & Berh (2009), a more common form of a basket CDS
is called first-to-default CDS, where as: the protection seller compensates the buyer of losses associated
with the first entity in the basket to default, after which the swap terminates and provides no further
protection (Rym Ayadi, 2009). CDSs that have higher numbers of reference entities are referred to as
portfolio products, which were used in connection to synthetic securitizations, and this transfers risk that
is associated with the CDS back to the CDO note holder. In such a transaction, a securitization, the legal
rights, or ownership of an asset (loan) is transferred to a special purpose vehicle (SPV). A CDO would be
considered a SPV. CDOs and CDSs are what in essence plummeted the markets in the global financial
crisis, in that CDOs would be structured of various financial instruments and then betted on. A CDO
involved transferred collateral loan obligations (loans, CLO) or collateral bond obligation (bonds, CBO)
or a combination of the two and these would be divided in tranches that would best attract investors.
Tranching allowed for sellers of CDO to specifically market and enlist their portfolios according to credit
ratings with the best being on top and working downward to junk-grade investments. As is evident, the
higher rating tranches had the lowest risk in comparison to lower rated tranches. Upon issuance, a report
would be provided to the derivative buyer that included the underlying obligations, scores, and ratings of
the tranches and this was seen as a form of regulation. A fairly common underlying portfolio of a CDO
could include assets such as corporate bonds, government bonds, commercial loans, and asset-backed
securities (ABS). These portfolios were managed at the discrepancy of the selling firms. Just like
preferred stocks the senior tranches the highest rated tranches had repayment priority over its lesser
counterparts (Ayadi & Berh 2009). Usually arranged in a way that an AAA rating was assigned to it, the
senior tranche accounted for most of the transaction volume, somewhere upwards of 90 percent.v
Another major source of growth in the OTC derivatives market came from index CDS, which
functioned like any other index fund, and these held tens, and hundreds of different CDS contracts. A
CDS index provides protection for all entities within the index. For instance, if a firm wanted to hedge
against the possible collapses of Lehman Brothers, Bear Sterns, LTCM, and AIG, rather than summoning

separate contracts, it could buy into an index that had these entities. This ultimately lowered transaction
costs and provided a speedier process in attaining protection against possible credit events. The two main
indices are the CDX indexvi, and the iTraxxvii index. In addition, CDSs were able to specify CDO as loan
and note obligations, giving a CDS the ability to be leveraged against a specific loan issued by another
firm. As a consequence, a CDS could be taken out against a loan that was not under the ownership of the
protection-buyer. This practice suffered great losses during the global financial crisis, because it caused
great stress and promulgated risk on firms unable to compensate for it.
DOCUMENTATION OF CREDIT TRANSACTIONS AND SETTLEMENTS
In constructing a CDS contract, several things must be associated and assigned. For instance,
various credit events must be agreed upon, and they could range from anything from failure to pay to
obligation default. The following are some of the most popularized credit events agreed upon during the
contractual stages of a CDS contract:
Default
Bankruptcy, is often associated with corporate reference entities more than governments
Debt restructuring can raise red flags for the parties of a CDS, especially if the reference entity is
a corporation. An example would be maturity extension in place of an imminent default. Often
referred to as an insignificant credit event, because a firm may simply want to restructure without
a case of defaulting. As a result motive is not always clear, thus it is given little recognition in
regards to other credit events.
Repudiation, when regarding government bonds, or investment activities. This provides for
speedy compensations after a specified action on behalf of the government reference entity.
Acceleration or defaulting on obligations, including such things as violation of a bond payment

covenant. (Transaction documentation and settlement, Ayadi & Berh 2009)

If the terms of a credit event are violated then the protection-seller must comply with regulations
and provide settlement. The two ways to provide payment in a CDS contract are physical settlement, and
cash settlement. A physical settlement involves the protection-buyer to readily deliver the defaulted debt
of the reference entity with the face value equal to the notional value specified to the protection-seller. In
return, the protection seller pays the par value: the face amount of the debt. If a credit event occurs and
the counterparties decide upon a cash settlement, the defaulted bond is then auctioned to determine the
post-default market value. Upon determination of the post-default market value of the bond, the
protection-seller pays the buyer the difference, which would give the protection-buyer the amount paid
for the CDS.viii
INHERENT CREDIT TRANSACTION RISKS
In addition to defining possible credit events and settlement procedures, firms desiring to entire
into CDS contracts must consider several inherent risks present in credit derivative transactions. If these
risks are improperly managed they may offset the assumed benefits of credit derivatives. The first of these
risks would be counterparty credit risk, which is usually seen as the most severe risk inherent with CDS
transactions because there is no promise of profitability. A simple way to measure counterparty credit risk
is to measure the current exposure risk at the current market value (this can also be conducted for future
exposure risk). This risk ultimately tells the parties of the contract, the likelihood of either party
defaulting, and is usually read in the firms credit rating. It is not unusual for firms to require collateral in
the agreements, to the affect that one party perceives future exposure that may be detrimental. For
instance, just days before its collapse, the financial conglomerate, Lehman Brothers, had fairly handsome
ratings that would allow for counterparties to favor contracts without collaterals. This turned out to be a
nightmare after Lehmans collapse. AIG, likewise, was given AAA ratings from various rating agencies,
allowing for favorable credit derivative contracts, without collaterals, but it too ultimately failed the
expectations of its counterparties.

Market liquidity risk is another risk in addition to counterparty credit risk inherent in credit
derivative transactions, and is a direct result of the failure of major financial institutions. A problem
present is the forced sales of positions in order to remain within the margin requirements. This would
conclusively drive down the price of the investment asset. If prices decline further, it may lead other
market participants to sell their positions, which could eventually dry out liquidity and produce an
unsatisfactory rating. This may introduce grounds for a default or recall. It is detrimental to the liquidity
of the market, if a market shock takes place, such as the default of a large reference entity or major market
maker.
Legal risk is the risk associated with the differentiation of parties involved in the contract. This is
more likely when the contract is poorly defined, such as terms and the misidentified reference entities. For
instance, J.P. Morgan has recently paid billions in order to have proper contracts that entail the
appropriate reference entities and terms. It can be detrimental when two firms conduct a CDS contract
and involve another untargeted reference. Even worse, is when the misappropriated entity has little to
no debt, which would make a CDS origination nearly impossible. Usually, documentation and legal risks
were readily overcome by major market-firms that developed common databases of all available
reference entities; thus creating necessary screening processes.
Operational risk would be another form of risk associated with CDS contracts. Backlogs of
unconfirmed trades, management trading reassignments, and settlement debacles are just some of the
issues created by ever-increasing complexity with new derivative products. But the priciest of risks
involved in a CDS contract was that of mis-pricing. Mis-pricing risk is inevitable in the derivative market,
especially in more complex derivative securities. The market for swaps include complex formulas created
by various corporations that would make one cringe. Formulas used to derive at a derivatives pricing
were not readily understood, and this caused risk for novice investors. If price distortions occur, this may
put the protection-buyer at a disadvantage because it could have to pay more in premium when prices are
set too high thus not properly reflecting the underlying risks. If an insuring firm misprices the CDS, this

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will leave the counterparty at a disadvantage and vice-versa. It is not always possible to price the CDS at
a correct number according to the underlying risks. The rating of a firm heavily influenced the pricing of
CDS contracts. If the firm was rated AAA or even AAa, protection-sellers might misprice the derivative,
purposefully, in order to receive excess premiums to profit from secure firms. But that is not always the
most likely of events as is evident in the global financial crisis (Risks inherent in credit derivative
transactions, Ayadi & Berh 2009).
Ultimately, financial institutions enter into credit derivative transactions as a way to better
manage risk and become better leveraged. This was the main reason the global financial crisis occurred,
overleveraged, and the use of toxic instruments such as mortgage-backed-securities (MBS). In theory
credit derivatives provide firms with an optimal overall risk assessment (profile) and helps to improve
profitability, efficiency and credit ratings. If properly used credit derivatives allow financial institutions
access to a broader range of risk-return combinations and underlying risks. Again, if properly used,
derivatives can help alleviate risk and provide for adequate hedging of troubled assets, and reduce
exposure. If it were not for improper usage of credit derivatives, the markets would probably have not
collapsed, but that is only a speculation, the very thing that brought Wall Street to distraught.
GLOBAL COLLAPSE OF 2008
The global financial crisis was a direct consequence of the continued deregulation and unethical
stance of the U.S. economic systems. With blurred regulations, the function of commercial and,
investment banks, insurance companies and real estate mortgage banking firms were, in retrospect, made
one, in that they could conduct business likened to one another. With that, companies became more
creative in their business practices, introducing differing financial instruments, some even toxic. For
instance instruments were derived that included: mortgage-backed securities (MBS), structured
investment vehicles (SIVs) which were forms of CDOs. These instruments were used by firms to provide
leverage, cash, hedge, and the ability to speculate the movement of the markets. A mortgage-backed
security (MBS) is a derivative security because the value thereof was derived from the mortgages (assets)

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in its portfolio, which would secure it, that is if monthly-mortgage payments were made. On the contrary,
a structured investment vehicle (SIV) was, technically, a virtual bank, which was operated by an
investment or commercial bank, but these operations were unrecorded in the firms balance sheet. The
purpose of a structured investment vehicle was to produce short-term funds to be propagated in long-term
investments of mortgage-backed securities, and by this, involving highly leveraged positions. Structured
investment vehicles usually invested in high-grade MBSs, which would provide detail into the risk-free
environment that it fostered. Ultimately, a SIV derived it value from the MBS it represented; thus if the
MBS lost value, the SIV followed suit. Collateralized debt obligations (CDOs) had also been a major
investor in MBS. According to Eun and Resnick (2014), an investor in a CDO is taking a position in the
cash flows of a particular trance, not in the fixed-income securities directly (Cheol S. Eun, 2014). In
retrospect, CDSs allowed for buyers of risky bonds the ability to convert the bond into a risk-free
investment. This allowed for companies to overly leverage themselves in hopes of producing higher
payouts. As a consequence, CDSs became the leading contract used against CDOs, which included things
such as bond and loan obligations, previously discussed (thus constituting MBSs as a CDO). The
emergence of CDS on the MBS market was rapid and as more mortgagees defaulted, the more attractive
bets on this form of derivatives became. From 2004 to 2008, the notional value of the credit default swap
market grew nearly ten-fold, from $6 trillion to $57 trillion (Stulz 2010). Credit default swap contracts
that insured default risk of a single firm was called single-name contracts, and likewise, of many firms,
multi-name contracts. Of the total credit default swap market, 80 percent of contracts were single-name
contracts, leading one to speculate specified targeting of failing firms. For instance, various firms betted
against Lehman brothers and expected to receive payments from Lehman on their derivatives. Targeted
and over-leveraged, Lehman crashed as soon as defaults occurred.
Key issues of the financial crisis included several things but at the top of the list would be the
misuse of credit derivatives and the poor understanding thereof. This led firms to reproduce derivative
risks on a more grand scale. Some key issues were:

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According to Rene Stulz (2010), banks and other financial institutions unfortunately held
mortgage products on which they made large unexpected losses. These unexpected losses were
produced by the misunderstanding of derivatives, their mispricing, and an inadequate
understanding of credit risks. Likewise, regulators did not require financial institutions to amass
capital because these institutions had bought protection, through CDSs, on their investment assets
further duplicating risks.
Losses on CDS pertaining to subprime mortgage-backed-securities was lead by major defaults

producing less liquidity for the payout of such losses, thus originating firms assumed risks. This
was a direct consequence of the web that is produced by credit default swaps, entangling one SPV
to various firms. Thus, if an institution failed in this web, it would have lead other institutions to
fail as they recorded losses on exposure. Thus exposure became another issue because it
heightened systemic risk. The uncertainty about the solvency of financial institutes was issued as
major market-makers were affected via the domino-effect produced by securitization (Credit
Default Swaps on Subprime Mortgage-Backed Securities, Stulz 2010).
According to Stulz (2010) credit default swaps heighten the concern of securitization, the
combination of firms betting on the same SVP, made the value of CDS jump, often by very large
amounts, when default occurred (Stulz 2010). Lehman Brothers, at the time of default, had
roughly one million derivative contracts on record with various financial institutions. Thus when
it failed, the notional amount was far too great for the firm to payout, causing it to declare
bankruptcy. When a firm contracts with numerous firms, it increases the counterparty risk. Would
the creditors default? Would the mortgagees default? How would payment be supplied if
defaulted? Lehman did not have answers to these questions because it was extremely entangled,
and at one point over-leveraged 90:1, raising risks of great uncertainty.
Another issue explored by Stulz (2010) was that the value of a contract, upon default, would be
greatly increased. To illustrate, suppose the market expected that there was a 30 percent chance

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that a dealer would default, and recovery would be 50 percent. If a default occurs, the value of the
bond falls to 50 percent, which was the recovery value, causing the bondholder to lose 50 percent.
The CDS would pay 50 percent. If the time value of money is ignored, the premium value of a
$20 million credit default swap contract for the protection-buyer would be $6 million (there was a
30 percent chance that the protection-seller would provide a payout, thus causing a premium of
$6 million to be required; this was a periodical total, most likely per annum). At default the value
of the credit default swap would be $14 million, leading the protection-seller to lose $8 million on
the day of. This was also another risk that protection-sellers did not fully grasp. Lehman did not
grasp this concept likewise because it could not payout on contracts days before its collapse. For
instance it cost only $700,000 to insure a $10 million contract. But upon default, Lehman would
payout over $9 million, a crippling number (Counterparty Risks and the Financial Crisis, Stulz
2010).
These are some of the risks presented when financial institutions do not properly regulate and
adequately understand the usage of financial derivatives. Improper use of credit derivatives led financial
institutions, such as Lehman Brothers and Bear Stearns to amass great debt without concern for assets.
These firms were dealers, thus their books were largely balanced and collateralized. These failed because
of securitization and the web-like environment created by the grand usage of credit default swaps.
Although, it can be argued that derivatives were not the proximate reason for the defaults of these firms, it
is conceivable that it was. If it were not for the improper usage of these instruments, perhaps the outcome
might have been different, or perhaps the global financial crisis may have been averted.
REGULATORY ACTIONS
Since the global financial crisis of 2008, the United States Congress, along with other
governmental agencies has enacted various laws and practices that have helped create a more adequately
regulated market, at home and abroad. On July 21, 2010, President Barak Obama signed into law the
Dodd-Frank Wall Street Reform and Consumer Protection Act (henceforth Dodd-Frank). The purposes of

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the act were to provide for financial regulatory reform, consumer and investor protection, an end to toobig-to-fail, to regulate the OTC derivatives market, and ultimately to prevent another financial crisis
(Evanoff & Moeller 2012). Likewise, the oversight and supervision of financial institutions were affected
along with provisions for new resolution procedures, capital requirements, compliance efforts, and OTC
regulations for large market-participants. Dodd-Frank called for the development of various new
regulatory rules and mandates. Of these mandates are: the requirement to introduce and staff a number of
new entities (offices, bureaus, and councils) with the responsibility of studying, evaluating, and
promoting consumer protection, and financial stabilities in the markets. Likewise, regulators are now
obligated to identify and increase regulatory scrutiny of systemic risk factors produced by large marketparticipants. Unlike previous attempts to regulate the OTC derivatives market, and other such markets,
the Dodd-Frank greatly differed in that it gave regulators more flexibility to reform regulatory agencies
and practices (Financial Stability, Evanoff & Moeller, 2012).
With that said, the act also imposed deadlines by which reforms had to be in place or studies
conducted causing financial institutions to become more efficient in their dealings with credit derivatives.
This time constraint produces significant pressures for regulators to meet deadlines while considering the
potential ramifications that their actions may have on the industry, or other adverse impacts on the
industrys ability to carry out its role in the markets. According to the report published by the Federal
Reserve Bank of Chicago by Evanoff and Moeller (2012), the Dodd-Franks most important objective
would be to ensure a stable and secure financial system. The act brought to light the inadequacy of
microprudential regulation, in that it was thought to have been enough to keep the markets safe during the
era of the crisis. As a result, macroprudential regulation was introduced alongside microprudential, and
this focused on the overall market stability and systemic risk, which was a key factor. The flaws of a
purely microprudential approach was that it ignored interconnections (web-process) and externalities,
not being considerate of one firms actions in consequence to other firms in the event of a spillover
(Financial Stability, Evanoff & Moeller, 2012). The act, introduced a consultative group of financial

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regulators known as the Financial Stability Oversight Council (the Council) along with the Office of
Financial Research (OFR), which helped regulators manage systemic risk. To accomplish this, the
Council had the authority to make appropriate macro-microprudential regulations, subscribe to collection
of information about market transactions, and institute important system activities that came under the
oversight of the Federal Reserve. The introduction of the Council was specifically designed to avoid
another regulatory bureaucracy, and instead bring together regulatory agencies together in a formal way
to contribute to public policy.ix The Council was a pivotal creation of the Dodd-Frank act in that it
enabled the supervision of risk-based capitals, leverages, liquidity and credit exposure, and ultimately
required firms to keep a tight-reign over such variables. The leading causes of failures, bankruptcies, and
market collapses were dealt with in the creation of the Financial Stability Oversight Council through
various mediums, ranging from leveraging, to capital requirements, to risk-management and debtobligations. The issue of Securitization was also dealt with and its transparency and risk factors mutually
debated. In that regard, credit risk retention policies were evident in curbing losses. In securitization
protection-buyers had to retain up to five percent of the risk involved in a contract; this rule applied to
CDOs and there was no longer a possibility to hedge or transfer risk (Morrison & Foerster). But firms that
used proper underwriting standards could be rewarded with a lower retention percentage. Financial
institutions dealing in securities had to provide required disclosures, which included: asset and data-level
details with material information regarding the loan brokers, originators, the nature of compensations, and
the amount of risk. In addition, credit rating agencies, such as Moodys and Standards & Poors, were
required to provide detail explanations into the nature of their ratings. This was something that they did
not do extensively during the global crisis. These are just some of the regulatory discrepancies that the
Dodd-Frank tackled and it is in no way the totality of the measure, which is far more extensive.x In
addition to providing for financial stability, the act allowed for the liquidity of troubled firms, of which
Lehman Brothers did not obtain and consequentially failed.xi Such bankruptcies had negative
externalities, of which the act favorably confronted.

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In title VII of Dodd-Frank, the framework for regulating the OTC derivatives market was
designated. Before the crisis, many desired to regulate the OTC derivatives market because, it represented
a risk to the financial system in that it lacked oversight, and risk-management tools (including a central
clearinghouse). The act brought the derivative market, with the exception of some swapsxii, under the
joint-control of the SEC and CFTC to improve transparency, governance and oversight (Morrison &
Foerster). The SEC would regulate security swaps, while the CFTC regulated other swaps, producing
somewhat of a separation of powers. In retrospect, the legislation imposed new requirements for financial
vehicles such as swaps (derivatives), the market participants (protection-sellers and buyers), and the
facilities where the trades were conducted (execution facilities and clearing organizations) (Derivatives
Regulation, Morrison & Foerster). Entities that functioned in market swaps were designated swap dealers
while non-dealer entities who participated in the trading of the swaps were designated major swap
participants (SD and MSP, respectively). Both SDs and MSPs had to register with the governing
agencies, thus producing accountability, transparency and safety in the financial markets. If the SD or
MSP did not have adequate regulations, they may have been required to maintain ample capital to
compensate. Other rules may include a limited exposure to credit derivatives as a consequence of
inadequate regulations. The purpose of title VII of the act was to ensure a more stable financial market
through the providing of regulatory powers confined in both the SEC and the CFTC. The Dodd-Frank act
is considered the cornerstone for financial reformation; it is what future financial regulations will be
measured up to.
CONCLUSION
Warren Buffet quipped that credit derivatives were financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially lethal. Some may argue that he was right while
others may not quite agree. In my view, if properly used and regulated derivatives may have bountiful
benefits to firms and investors contracting them. Credit derivatives, in theory are designed to make for a
more efficient and stable market. It therefore permits individuals and firms to achieve payoffs that would

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otherwise not be achievable without the use of derivatives, or at increased costs. Likewise, the possibility
of hedging against future risks that would otherwise not be possible to hedge is made possible through
credit derivatives. As stated earlier, in theory, derivatives can make for a more efficient market by the
production of information. It is through swaps that some long-term interest rates are obtained because that
market is more active and liquid than the bond market. It levels the playing field by allowing investors to
invest on information that might otherwise have been expensive to acquire. For instance, when short
selling a stock, transaction times are slowed down because one has to borrow bought shares from another
investor, making it less efficient. With an option, which is a derivative that is essentially a short position,
the investor can more easily acquire these same stocks, with relevant information at the exact price
determined. This ultimately speeds up trading, improves market efficiencies and produces a more liquid
system.
Credit derivatives allow firms to hedge risks or at a bare minimum the costs of hedging such
risks. It cuts both ways; a derivative may greatly benefit through improved performance or may create
systemic risk, usually caused by firms that are unethical in the market. In an interconnected economy a
collapse of a large market-participant may imply greater systemic risk, and this was evident in the
collapse of large multinational enterprises, including Lehman Brothers, AIG, Bear Stearns, and Merrill
Lynch. It is imperative that both derivative users and regulators, especially with the introduction of the
Wall Street Reform Act, be cautious and vigilant about said transactions. Firms must be able to check off
on the risks previously presented (such as counterparty risks, legal risks, market exposure risks). It is
believed that the derivatives market is fairly regulated, although not as well as one would like, but
nonetheless regulated. Today, various derivatives are actively traded and major firms and clients profit
from their use. Interest rate swaps compile the largest portion traded for the derivatives market, with
hundreds of trillions in notional value. Options and insurance contracts (CDS) are still traded but with
more careful oversight by said agencies and federal regulations. In previous years a more interest-derived
instrument has gained popularity: namely, the Bit coin. The Bit coin is an electronic currency derivative

18
product, which has a value of its own produced by the activity of the market (Bit coin market). It is also
speculated that there appears to be another housing bubble, or credit bubble compiling now, and that the
usage of credit derivatives may imply another financial crisis. Should we fear credit derivatives? Should
we denounce them as completely unethical or as a nuisance? Perhaps not. We believe that planes are
fairly safe, and that it is economically sound to travel long distances via one, thus we board it without
giving another thought. This same logic should be given to credit derivatives; they are economically
sound and safe in the proper contexts. Although this form of derivatives is new and has posed great
threats to the global markets, it should not be resigned as, what Google decided to quip, as worst Wall
Street invention. A life without proper boundaries, and rules is reckless, and not civil, leading to great
damage, but with boundaries it can be a bounty of wealth and thus is the case with credit derivatives.
REFERENCES AND NOTES

19
Rym Ayadi, P. B. (2009). On the necessity to regulate credit derivative markets. Journal of Banking Regulation,
10(3), 179-201. Retrieved from www.palgrave-journals.com/jbr/
ii
BIS surveys of OTC derivatives market statistical release
iii
BIS survey of OTC derivatives market statistical release
iv
Stulz, R. M. (2005). Demystifying Financial Derivatives. The Milken Institute Review, 20-31.
Rym Ayadi, P. B. (2009). On the necessity to regulate credit derivative markets. Journal of Banking Regulation,
10(3), 179-201. Retrieved from www.palgrave-journals.com/jbr/
vi
CDX is the family CDS index products covering North America and emerging markets. The Markit Group
Limited owns, manages, compiles and publishes this index from the leading industry source for pricing and
valuation. The CDX consists of 125 North American investment-grade firms.
vii
iTraxx is the family CDS index products covering European and Asian markets. The rules-based indices comprise
the most liquidable entities in the European and Asian credit markets, and they consist of iTraxx Europe, iTraxx
Hivol, iTraxx Crossover, iTraxx Asia ex-Japan, iTraxx Japan, iTraxx Australia, and various others. This index was
primarily owned by the International Index Company (IIC), but is now jointly operated by the IIC and the Markit
Group Limited. It is considered the benchmark for European and Asian credit markets.
viii
Main Characteristics of CDS transactions

Cash Flows
Protection buyer pays regular premiums over the life of the swap
Protection seller pays amount (depending on the agreed
settlement procedures) following the credit event.
Reference Entity
Usually investment grade rated corporations, banks and
sovereigns from developed countries.
Risks Involved
Counterparty credit risks the risk that the transaction
counterparty defaults before the final settlement of the
transactions cash flow protection seller defaults on contingent
payouts and protection buyer defaults on premiums.
Legal risks credit event definitions do not cover all potential
risks (every potential).
Market liquidity risk A decline in asset market liquidity as a
direct failure of one or more major participants in the CDS
market.
Operational risks.
Types of CDS
Standardized Contracts
ISDA Master Agreements
Trigger Events
ISDA standard credit event default, failures, obligation
default, restructuring of debt.
Settlement in the case of a credit event
Physical Settlements
Cash Settlements
Source: Ayabi & Behr and own research on ISDA websites
ix
The Council consisted of ten members, each having voting powers, and five nonvoting members. This Council
was made up of federal and state regulators and an insurance expert appointed at the pleasure of the President. The
voting members are: (1) Secretary of the Treasury, who serves as chairman of the Council; (2) Chairman of the

20

Board of Governors of the Federal Reserve System; (3) Comptroller, OCC; (4) Director of the Bureau of Consumer
Financial Protection; (5) Chairman of the Securities and Exchange Commission; (6) Chairman of the FDIC; (7)
Chairman of the Commodity Futures Trading Commission (CFTC); (8) Director of the Federal Housing Finance
Agency (FHFA); (9) Chairman of the NCUA board; and (10) Insurance expert appointed by the President. The
nonvoting members, who are serving as advisors are: (1)Director of the Office of Financial Research; (2) Director of
the Federal Insurance Office; (3) State insurance commissioner; (4) State banking supervisor; (5) State securities
commissioner (or officer).
x
The Dodd-Frank act includes other categories that cover reforms ranging from: investor protection, credit rating
agencies, the Volcker rule provisions, compensation and corporate governance, and capital requirements. In regards
to the use of derivatives, the section: Investor protection reformation included such topics as liability and
disclosures, custody and client request (relationship), conflicts of interest, short sales and SEC powers. Credit rating
agency reformation included a massive portion of liabilities and required disclosures on behalf of the credit rating
agencies. The three major rating agencies are: Moodys, Fitch, and Standards and Poor. The Volcker rule, named
after Chairman Paul Volcker, operated under the premise that speculative trading was a key contributor in the
financial crisis, thus it desired to prohibit such transactions. With that said Proprietary trading was outlawed. It is
defined as the engaging of trades on accounts of banking entities, or nonbank financial companies in transactions to
sell, acquire, dispose of any security, any derivative and any contract of sale of a commodity for future delivery. In
addition to prohibited trades, the rule does allow for some permitted activities including: transactions in U.S.
government bonds, underwritten transactions (of which the contracts are reasonable and do not exceed obscure
terms), risk-mitigating hedge activities so long that they are used with banking entities, contracts or holding firms
that are specifically designed to reduce risk, and SBIC investments, and organized hedge fund activities (private
equity). Finally, the act discusses the issue of capital requirement, which was kept at a bare-minimum by investment
firms during the financial crisis. This amendment required that banks or nonbanks companies that held total
consolidated assets of $50 billion or more to establish risk-based capital requirements, leverage limits, and liquidity
requirements. These were in essence bars against the dangers of firms becoming insolvent. These, and various other
rules, are incorporated in the Dodd-Frank Act.
xii
Forward contracts on commodities that are for physical delivery are exempt, along with foreign exchange swaps
and foreign exchange forwards. These are not defined as a swap.
Evanoff, D., & Moeller, W. (2012). Dodd-Frank: Content, purpose, implementation status, and issues. Economic
Perspectives, (0164-0682), 75-84. Retrieved March 1, 2015.
Morrison & Foerster. (n.d.). The Dodd-Frank Act: A cheat sheet. 4-25.
Stulz, R. (2010). Credit Default Swaps and the Credit Crisis. Journal of Economic Perspectives, 24(1), 73-92.
Retrieved February 1, 2015.

Financial Derivatives: A Perceived Value

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RUNNING HEADER: FINANCIAL DERIVATIVES: A PERCEIVED VALUE