Regulating credit default swaps as insurance: a law and economics perspective

Matthew A. Zolnor

Matthew A. Zolnor is a Student at the College of Law, Florida State University, Tallahassee, Florida, USA.

Abstract Purpose The purpose of this paper is to analyze a recent proposal by the State of New York that would subject a large portion of the credit default swap (CDS) market to state-based insurance regulatory oversight. Design/methodology/approach Using the collapse of AIG as an example of the systemic risk inherent in unregulated CDS transacting, the Coase Theorem is then applied to determine the optimal level of CDS regulatory oversight. Findings Although CDSs resemble insurance contracts in many respects, they are also uniquely complex nancial instruments that are continually changing and thus not well suited for the antiquated state-based model of insurance regulation. Furthermore, the external forces that inuence state-based regulatory decision-making are likely to produce inefcient regulation. Practical implications The Coase Theorem states that the optimal level of regulatory oversight is the one that causes market participants to internalize the risk inherent in transacting and does so at the lowest cost. Because of the complexity of CDS contracts and the unique forces that guide state-based regulatory decision-making, the State of New Yorks proposal is ill advised. Originality/value By utilizing a law and economics perspective, it becomes clear that although a state-based model of regulatory oversight may force market participants to internalize systemic risk, it is nevertheless suboptimal because it does not do so at the lowest cost. Keywords Insurance, Financial instruments, Credit control, United States of America Paper type Technical

I. Introduction
Our current economic crisis is the result of a loosely regulated and increasingly complex mortgage lending system. The loose regulatory framework in the primary mortgage market encouraged irresponsible lending[1]. The problem was exacerbated by the proliferation of the mortgage securities market, which further incentivized the issuance of subprime loans in the primary market (Werrett, 2009). These loans were then pooled into complex security instruments called collateralized debt obligations (CDOs)[2]. Banks began selling credit default swaps (CDSs) as a form of insurance on the value of the CDOs. However, low interest rates and low threshold loans created a housing bubble that burst. As home values fell so too did the value of the CDOs, which caused billions of dollars worth of CDSs to become payable (Werrett, 2009). Unfortunately, large mortgage lending institutions and banks were undercapitalized and underinsured for the losses incurred in the primary and secondary markets (Werrett, 2009). As a result, the federal government was forced to step in and bailout several of the banks and nancial intermediaries contributing to the disaster. Much of the debate regarding the current nancial crisis involves the especially destructive role that CDSs had to play. A CDS is a unique and relatively novel type of credit derivative contract in which a protection buyer pays a premium to a protection seller in exchange for

PAGE 54

JOURNAL OF INVESTMENT COMPLIANCE

VOL. 10 NO. 4 2009, pp. 54-64, Q Emerald Group Publishing Limited, ISSN 1528-5812

DOI 10.1108/15285810911007435

the seller agreeing to compensate the buyer on the happening of a credit event, such as a third party defaulting on a loan (Shadab, 2009). In the wake of the recent economic meltdown, it has become clear that a lax regulatory framework created a CDS market that incentivized the very behavior that CDS regulation ought to proscribe. As a result of the regulatory black hole, the CDS market exploded over the past decade, becoming worth more than $45 trillion, dwarng the US stock, treasury and mortgage markets combined (Morrissey, 2008)[3]. However, when properly crafted, CDSs are immensely benecial and stand to play an integral role in the restoration of our economy (Stulz, 2009). The goal of this article is to analyze a recent regulatory proposal that would subject a large portion of the CDS market to the regulatory oversight of the New York State Insurance Department (NYSID)[4]. Employing the logic of the Coase Theorem, I explain that the optimal level of regulation is the one that causes market participants to internalize the risk inherent in transacting and does so at the lowest cost. After an examination of the unique characteristics of CDSs and the external forces that inuence state-based regulatory decision-making, I propose that New Yorks proposal is ill advised.

II. The economics of regulation

The purpose of Part II is to highlight the fundamental economic principles that ought to guide economic regulation. First, Part II introduces the Coase Theorem and how it denes if and when regulation is desirable. Second, I explain the systemic risk inherent in CDS transacting in an effort to determine the point at which CDS regulation is warranted. Part II of the paper closes by explaining the especially destructive role CDSs played in the collapse of AIG, which has renewed the debate regarding the necessity of CDS regulation. A. The Coase Theorem Ronald Coases (1960) The Problem of Social Cost[5] explains precisely when and to what extent economic regulation is warranted. Coase realized that people are maximizers (Falaschetti and Orlando, 2008) and will thus rationally exploit all mutually benecial transactions. However, transaction costs often limit peoples ability to effectuate mutually benecial transactions (Coase, 1960). When transaction costs become prohibitively high, regulation can expand total output by requiring market participants to internalize the costs they once externalized (Coase, 1960). However, regulation itself can impede mutually benecial transactions if it imposes more costs on market participants than did the conduct it proscribes (Coase, 1960). Thus, the unique insight offered by the Coase Theorem is two-fold: regulation is only successful when: transaction costs exist, and the costs of complying with the regulation do not outweigh the benets of proscribing the regulated behavior. Ultimately, the ideal regulatory framework is the one that assigns liability or proscribes the conduct of the party able to mitigate the harm at the lowest cost (Coase, 1960). B. CDSs and systemic risk Systemic risk has been a topic of much debate in recent months (Beville, 2009)[6]. For purposes of this article, systemic risk may be dened generally as the risk that the default of a rm or group of rms will result in the failure of the nancial system as a whole in this case, when the default of that rm or group of rms was caused by overleveraging through CDSs. Ideally, we want market participants to be free to negotiate the terms of CDS contracts. Freedom benets the market as a whole because it facilitates the development of innovative CDS contracts, which provide liquidity and risk-shifting opportunities. But the freedom of contract is benecial only to the extent that market participants sufciently internalize the risk inherent in CDS transactions.

VOL. 10 NO. 4 2009 JOURNAL OF INVESTMENT COMPLIANCE PAGE 55

In the ideal market, i.e. one without transaction costs, buyers are able to accurately identify counterparty risk (Sjostrom, 2009)[7] and adjust bid prices accordingly. Because counterparty risk is accurately identied, rms selling CDSs are generally able to make good on their obligations under the contract in the unlikely event that those obligations become due. In this ideal market, rms selling CDSs remain solvent and thus pose little risk to the nancial system. In this scenario regulation can serve no purpose because market participants have adequately internalized the risk inherent in CDS transactions (Coase, 1960). The problem is that market participants are maximizers and price only the internal costs and benets of CDS transacting (Falaschetti and Orlando, 2008). Market participants on both sides of the transaction have an incentive to ignore the risk overleveraged CDS transactions pose to the system as a whole[8]. When the value of the underlying security declines and the CDS becomes payable, overleveraged rms become insolvent, which increases the risk of the failure of the entire nancial system. It is at this point that regulation is warranted, but that is not the end of the matter. Recall that the Coase Theorem highlights that regulation is only successful when the costs of complying with the regulation do not outweigh the benets of proscribing the regulated behavior (Coase, 1960). In other words, the optimal regulatory framework is the one that assigns liability to, or proscribes the conduct of, the party that is able to mitigate the harm at the lowest cost (Coase, 1960). The competing interests of the freedom to contract on the one hand and the private incentives market participants face on the other have provided for differing levels of regulation for derivatives and CDSs over the past few decades. In the next section I discuss the state of regulation exercised up until the 1980s, when the derivatives market was rapidly deregulated. The deregulation created a CDS market in which market participants did not properly internalize systemic risk, which, in turn, led to the collapse of AIG and renewed the debate regarding the necessity of CDS regulation. C. The fall of AIG: an example of systemic risk renewing the debate regarding CDS regulation i. The regulatory landscape pre-AIG. Until the 1980s, derivative contracts were regulated by the Commodities Future Trading Commission (CFTC) and could only be traded on regulated commodities markets (Hazen, 2009). During this period, the CFTC had to pre-approve the economic integrity of prospective derivative contracts (see Hazen, 2009, p. 8). Because all derivative contracts entered into were approved by the CFTC, derivative sellers were generally able to make good on their commitments under these contracts in the event of default. However, the pre-approval process limited the variety of derivative contracts that could be bought and sold. As a result market participants lobbied for deregulation. Recall that regulation stands to either promote or impede mutually benecial transactions and that successful regulation only regulates to the extent that the costs of regulatory compliance do not outweigh the benets (Coase, 1960). The lobbyists arguing for the deregulation of the derivatives market believed that the CFTCs pre-approval power limited market participants ability to create mutually benecial transactions (Hazen, 2009, p. 7)[9]. As a result, the CFTCs regulatory oversight was dramatically reduced with the passage of the Commodity Futures Modernization Act (CFMA) in 2000, shortly after CDS contracts were rst traded in the mid-1990s (see Hazen, 2009; see also Teather, 2008). The CFMA amended the Securities Act of 1933 and the Securities Exchange Act of 1934 to specically exclude from the denition of a regulated security any security-based swap agreement (see Sjostrom (2009, p. 37). The most important effect was that it revoked the CFTCs pre-approval power, which created a new, rapidly expanding and almost entirely unregulated over-the-counter CDS market. The rapid deregulation of the CDS market stood to benet the nancial system as a whole because freedom to contract promotes innovation. However, the system stands to benet only to the extent that market participants sufciently internalize the systemic risk inherent in

PAGE 56 JOURNAL OF INVESTMENT COMPLIANCE VOL. 10 NO. 4 2009

free CDS transacting. In the next section I discuss how the fall of AIG proves that the newly deregulated CDSs did not sufciently cause market participants to internalize that risk. ii. The AIG collapse explained. AIG is a holding company which, through its subsidiaries, is engaged in a broad range of insurance and insurance-related activities in the USA and abroad (American International Group, Inc., 2008). Its primary business divisions are General Insurance, Life Insurance and Retirement Services, Financial Services and Asset Management (American International Group, Inc., 2008). It was AIGs Financial Products Corp., AIG Trading Group, Inc. and their respective subsidiaries (collectively AIGFP) that engaged in CDS transactions (American International Group, Inc., 2008) and were at the root of its ultimate downfall (see Sjostrom, 2009). AIGFP incurred $32 billion in losses between January 2007 and September 2008 and those losses are almost entirely attributable to its overleveraged CDS portfolio (see Sjostrom, 2009, p. 4). To fully grasp the effect that CDSs had on AIG and the market as a whole, it is important to understand the mortgage securitization process generally. The process begins with a lender issuing a mortgage loan to a buyer in order to nance the purchase of a home (see Sjostrom (2009, p. 9). The lender then sells that loan, along with other loans it made during the same period, to an institution called an arranger (see Sjostrom, 2009, pp. 9-10). The arranger sells those loans, along with other loans it has purchased, to a special purpose vehicle (SPV) (see Sjostrom (2009, p. 10). In order to fund the purchase of the pooled loans, the SPV issues debt obligations, called asset-backed securities (ABSs), which provide claims to the cash ows produced by the pooled loans (Sjostrom, 2009). Typically the SPV divides the debt obligations it issues into different tranches, often junior, mezzanine and senior tranches (Sjostrom, 2009). The tranches are divided in order to indicate payment priority (Sjostrom, 2009). Generally, the obligations are to be paid out to the senior tranche rst, then to the mezzanine tranche, and nally to the junior tranche (Sjostrom, 2009). The different tranches are rated by credit rating agencies (Sjostrom, 2009). Although a senior tranche may not be backed by any triple-A rated assets, it may nevertheless receive a triple-A rating because it is the rst to receive payouts and the last to incur losses (Sjostrom, 2009, pp. 10-11). Despite the high credit rating of many of the ABSs, there has been an enormous demand for insurance on these securities in the form of CDSs (Sjostrom, 2009, p. 11). This is where AIGFP came into play. By the end of 2007, AIGFP had issued CDSs insuring a net notional value of $527 billion worth of triple-A rated tranches of securities (Sjostrom, 2009, p. 12). AIGFP earned billions of dollars in revenues through its CDS portfolio, but the buyers of its CDS protection beneted as well. Many nancial institutions bought AIGFP CDSs in order to attain regulatory capital relief (Sjostrom, 2009). By buying CDS protection from AIGFP, these institutions were able to reduce the amount of capital they were required to maintain by regulatory mandates (Sjostrom, 2009). This aspect of the AIGFPs CDS activities severely increased systemic risk and was a major factor leading to our current nancial crisis. Recall the discussion in Part II.B above. The regulatory capital relief these CDS transactions provided demonstrates how market participants on both sides of the transaction had an incentive to ignore the risk inherent in CDS transacting. However, AIGFP and the institutions it did business with stood to benet from the CDS transacting only so long as the value of the securities underlying the CDSs remained stable. Unfortunately, they did not. A net notional amount of $61.4 billion of AIGFPs CDS portfolio insured collateralized debt obligations (CDOs), a type of ABS that were backed by subprime mortgages (Sjostrom, 2009, p. 15). When a large portion of subprime borrowers defaulted on their loans, AIGFPs obligations under the CDSs it issued became due. This caused massive write-downs in AIGFPs CDS portfolio ($11.2 billion in 2007 and $19.9 billion in the rst nine months of 2008) and forced AIGFP to post billions of dollars in collateral (Sjostrom, 2009). As a result, the credit ratings agencies downgraded AIGs long-term debt rating, which caused an additional $20 billion of CDS obligations to become due (Sjostrom, 2009, p. 18). It was at this

VOL. 10 NO. 4 2009 JOURNAL OF INVESTMENT COMPLIANCE PAGE 57

point that the federal government decided to step in and issue an $85 billion loan to the insurance giant (Sjostrom, 2009, p. 1). The collapse of AIG is a quintessential example of systemic risk. As discussed previously, the deregulation of the CDS market created a situation in which AIGFP and the nancial institutions to which it sold CDSs did not have incentives to internalize the risk inherent in CDS transacting. These market participants chose instead to internalize only the private costs and benets. As a result US taxpayers have been forced to foot the bill as federal government aid provided to AIG has since grown to $200 billion (Sjostrom, 2009). AIG was one of the biggest players in the CDS market, but certainly not the only one. In fact, AIGs $527 billion CDS portfolio accounted for less than 1 percent of the nearly $58 trillion CDS market (Shadab, 2009, p. 8). Considering the level of systemic risk unregulated CDS transacting poses, the debate regarding CDS regulation has been renewed. In the next section I employ the logic of the Coase Theorem in an effort assess recent regulatory reform.

III. Regulating credit default swaps as insurance

The CDS market can essentially be divided into two parts, one of which is the so-called covered portion of the CDS market. This portion of the market includes those CDS contracts in which the buyer owns the underlying asset or security that the CDS is designed to insure. The other part of the market commonly referred to as the naked CDS market, is comprised of the CDS contracts in which the CDS owner does not own the underlying asset or security. In the wake of the collapse of AIG, there have been numerous proposals for the reform of the CDS market both at the state and federal levels (see Forrester et al., 2009). On September 22, 2008, New York Governor David Paterson announced that covered CDS transactions would be subject to the regulatory oversight of the NYSID beginning in January 2009 (State of New York, 2008). The same day the NYSID issued Circular Letter No. 19, which outlines the States plan[3]. The Circular Letter indicates that the selling of covered CDSs may now constitute the doing of an insurance business under Article 69 of New York Insurance Law, which would require covered CDS sellers to be licensed by the State[10]. In June 2009, the proposal was amended to exempt only those CDSs that the NYSID deems otherwise effectively and comprehensively regulated (see Forrester et al., 2009). However, the States plan has since been tabled in light of pending federal regulatory proposals, which could ultimately render a state-based regulatory model unnecessary (Forrester et al., 2009). Despite its amendments and postponement, New Yorks proposal, and others like it, could nevertheless be enacted in the near future (Forrester et al., 2009)[11]. The purpose of this paper to is to explain why such proposals are ill advised. There are several reasons why one would support New Yorks regulatory proposal, particularly in light of AIGs recent downfall. AIG is involved in number of different business sectors each of which is subject to differing levels of regulatory oversight[12]. What has become clear is that it was those AIG divisions subject to federal regulatory oversight that failed while those divisions subject to state-based regulatory oversight did not. In fact, all 71 of the insurance providers held by AIG and subject to regulatory oversight at the state level remain solvent and fully capable of fullling their policy obligations[13]. The AIG bailout would have greatly exceeded $85 billion had those divisions failed, which some argue serves as a testament to the virtues of state-based regulation[13]. It seems logical to assume that had AIGFP been regulated at the state level, the current economic crisis may have been far less severe, or prevented altogether. This argument is especially appealing because covered CDSs closely resemble traditional insurance contracts. But is important to remember that forcing market participants to internalize costs is only part of the matter. Although a state-based model of regulatory oversight may effectively force market participants to internalize the risk inherent in CDS transacting, it may nevertheless be suboptimal if it does not do so at the lowest cost[14].

PAGE 58 JOURNAL OF INVESTMENT COMPLIANCE VOL. 10 NO. 4 2009

With that principle in mind, in the following sections I examine whether a state-based regulatory framework of the CDS market is the optimal regulatory solution. I begin by providing a brief introduction to modern insurance regulation after which I discuss some lessons that are to be learned from software development and intellectual property law. I then examine the unique forces inuencing state-based regulatory decision-making. Ultimately, it will become clear that the State of New Yorks plan to regulate the covered CDS market is ill advised. A. Insurance: a brief background Insurance has been and continues to be regulated at the state-level (Tennyson, 2007). A unique aspect of the insurance market is that insurers are allowed to pool information for rating purposes (Tennyson, 2007). The pooling of information allows insurers to predict more accurately which reduces total risk (Tennyson, 2007, p. 3). The McCarran Ferguson Act alleviated any anti-competitive concerns by partially exempting the insurance industry from antitrust laws (Tennyson, 2007). The McCarran Ferguson Act also denitively declared that business of insurance was to be regulated by the states (Tennyson, 2007). The Act states:
Congress hereby declares that the continued regulation and taxation by the several States of the business of insurance is in the public interest, and that silence of the part of the Congress shall not be construed to impose any barrier to the regulation or taxation of such business by the several States (Baker, 2003).

As a result, states have the authority to regulate every aspect of the insurance business including, but not limited to, licensing (of insurance companies and intermediaries), taxation, solvency, rates, forms, access and availability, and market conduct (Baker, 2003, p. 123). The differing state regulatory frameworks are coordinated, to a certain degree, by the National Association of Insurance Commissioners (NAIC) (Baker, 2003). The result is a modern insurance industry that is subject to vastly differing levels of regulatory oversight from state to state. There are arguments supporting and criticizing the current regulatory framework. In the next sections I examine these arguments and conclude that the unique forces inuencing state-based regulatory decision-making outweigh any benets such a model provides. B. Are covered CDSs insurance contracts? Lessons to be learned from intellectual property law CDS contracts, particularly covered CDSs, closely resemble traditional insurance contracts. This likely served as a major factor motivating the State of New Yorks decision to bring them under the regulatory oversight of the NYSID. However, just because covered CDSs resemble insurance contracts does not necessarily mean that a state-based regulatory framework is optimal. An examination of intellectual property (IP) laws and software development helps make this point clear. Historically, the line separating patentable IP and copyrightable IP was clear (Abbott et al., 2007). Patents generally protected industrial property while copyrights protected artistic or literary property (Abbott et al., 2007). Software developers rst sought protection of their IP under the provisions of copyright law (Abbott et al., 2007). Their rationale was that the code used to write software most closely resembled traditional copyrighted property like books or other literary works (Abbott et al., 2007). But the IP protection that copyright provides is limited to the authors creative expression, which courts have interpreted to exclude the ideas or methods of operation that may be manifested in those works[15]. The limited scope of copyright protection has presented myriad problems for software developers, regulators and courts[16]. This is because the characteristics unique to software blur the lines between creative expression and technological innovation. As a result, market participants have been forced to bear the cost of seeking IP protection through alternative means[17]. The lessons learned from IP law pertaining to software development are directly applicable to the CDS regulatory debate. Proponents of a New Yorks regulatory decision argue that

VOL. 10 NO. 4 2009 JOURNAL OF INVESTMENT COMPLIANCE PAGE 59

covered CDSs meet the insurable interest requirement, a hallmark of traditional insurance regulation. New Yorks insurance law provides a typical denition of the insurable interest requirement:
No contract or policy of insurance on property made or issued in this state, or made or issued on any property in this state, shall be enforceable except for the benet of some person having an insurable interest in the property insured. In this article, insurable interest shall include any lawful and substantial economic interest in the safety or preservation of property from loss, destruction or pecuniary damage[18].

Because buyers of covered CDSs own the underlying asset that the CDS protects, one could argue that the CDS protects a lawful and substantial economic interest in the safety or preservation of property from loss, destruction or pecuniary damage. However, the fact that covered CDSs might meet the insurable interest requirement is not, in and of itself, a sufcient reason to subject them to state-based regulatory oversight. I contend that that regulating CDSs as traditional insurance contracts could create myriad problems for market participants much like those discussed with respect to software above. First of all, CDSs are more than traditional insurance contracts in much the same way software is more than traditional copyrightable IP. CDSs blur the lines between a variety of complex nancial instruments including futures, derivatives and securities beyond those aspects common in insurance contracts (Hazen, 2009, p. 15). Second, the CDS market is facing rapid innovation and globalization in much the same way software IP did in the late twentieth and early twenty-rst centuries as a result of evolving technologies. Subjecting it to vastly differing regulatory frameworks from state to state could create growing complexities for CDS market participants and impede mutually benecial transacting. Ultimately, I contend that the state-based model of insurance regulation is an antiquated system that is not well suited for CDS regulation. With this in mind, I now turn my attention to the unique forces that guide state-based regulatory decision-making as further evidence that New Yorks regulatory proposal is ill advised.

C. State-based regulation does not enhance efciency There are several arguments for the efciency of a state-based model of regulation. The most prevalent of these arguments are that:
B

state regulators are better able to regulate for the unique needs of their economies (Baher, 2005)[19]; state-based regulation allows states to compete for efcient regulatory mechanisms (Grace and Phillips, 2007); and state-based regulation promotes regulatory innovation (see Baher, 2005, p. 390).

However, these arguments do not hold up when the external forces that inuence state-based regulatory decision-making are properly considered. One benet, many argue, of state-based regulation is that local government ofcials are better suited to design regulation for the unique needs of their own economies (Baher, 2005). The aw in this argument is that it presumes that local government ofcials always act in the interest of the public and fails to consider the external forces that inuence their regulatory decision-making. Local government ofcials are maximizers and thus rationally price only the internal costs and benets of a given action (Falaschetti and Orlando, 2008). So although these ofcials may stand in a better position to identify the needs of their constituents, they may nevertheless enact inefcient regulation (see Grace and Phillips, 2007, p. 212). Studies have shown that external forces often inuence suboptimal regulatory decision-making[20]. These forces include the possibility of reelection (see generally Besley and Case, 1995), the politics of the state (see generally Poterba, 1994) or pressure from special interest groups (see generally Peltzman, 1976).

PAGE 60 JOURNAL OF INVESTMENT COMPLIANCE VOL. 10 NO. 4 2009

A good example of the external forces that inuence regulatory decision-making is the recent regulatory action implemented in the State of Florida. In response to the states punishing rate regulation, State Farm, Floridas largest insurer of private property, announced plans to withdraw from the Florida property insurance market over the next two years (Fineout, 2009). State Farm was badly hurt by the devastating hurricane seasons of 2004 and 2005. In an effort to recoup costs, the insurer requested a 47 percent rate increase, but was denied by state regulators (Wall Street Journal Review and Outlook, 2009). State Farm requested the rate increase because since 2000 State Farm has paid out $1.21 in claims for every $1 of premium received (Wall Street Journal Review and Outlook, 2009). As a result State Farm loses $20 million every month it continues doing business in Florida (Wall Street Journal Review and Outlook, 2009). State Farm is but one of the many insurers that are being forced out of Floridas property insurance market. These also include Prudential, Allstate, Nationwide and USAA (Wall Street Journal Review and Outlook, 2009). The withdrawal leaves over a million policyholders without property insurance. The affected policyholders are now seeking coverage from Citizens Property Insurance Corp., a state-based insurance company, which was created by Florida Governor Charlie Crist in 2007 (Wall Street Journal Review and Outlook, 2009). Mr Crist stands to benet from the withdrawal of State Farm. In the eyes of voters, Mr Crist is standing up to the big, bad insurance company while providing Floridians with cheaper property insurance coverage through Citizens. But the problem is that Citizens is severely under-capitalized and if Florida is hit by another severe hurricane, the insurer will not be able to pay claims when they come due (Wall Street Journal Review and Outlook, 2009). Instead, Mr Crist will be forced to either raise taxes on Floridians or seek a bailout from the federal government (Wall Street Journal Review and Outlook, 2009). In other words, Mr Crist is internalizing the benet of gained favor among voters, but none of the costs that will be incurred in the event that Citizens fails. Another argument in favor of state-based regulation is that it permits states to compete for effective regulation (see Grace and Phillips, 2007, pp. 208-209). States derive substantial revenues from the taxes levied against insurers doing business within their boundaries. In 2000 the average state incurred just $17 million in domestic regulatory costs while gaining $204 million in tax, licensing and other revenues (see Grace and Phillips, 2007, p. 211). So it would seem logical for states to compete for those revenues by implementing efcient regulatory mechanisms that attract insurers. However, this argument does not hold up when externalities are properly considered. Insurance is an interstate business. Of the total insurance policies written in the average state in 2000, only 12.74 percent were written by in-state insurers (see Grace and Phillips, 2007 p. 209). This creates the potential for devastating spillover effects. By way of illustration, let us assume that State A implements relatively lax solvency requirements in an effort to draw insurers to the state. The insurers domiciled in State A will likely write the majority of their policies for consumers outside the state. If those insurers become insolvent as a result of minimal regulatory oversight, State A will only be forced to cover those policies written for consumers in State A. In other words, State A gets to enjoy all the benets created by the inefcient regulation, but bears only a small portion of the costs it creates. Yet another argument for state-based regulation is that allowing states to develop differing regulatory mechanisms promotes regulatory experimentation and innovation (see Baher, 2005, p. 390). According to this argument, if one state creates an innovative regulatory mechanism, other states are likely to implement it as well. However, this logic is also awed because it fails to recognize the correct forces motivating regulators (see for example Grace and Phillips,2007, p. 235). Another example may prove helpful. Assume that regulators in State A design and implement an innovative regulatory mechanism. Proponents of this argument would argue that regulators in States B, C and D have an incentive and are likely to implement similar regulation, but that is not the case. Recall once more that state regulators are maximizers and external forces inuence their regulatory decision-making. Although it may be more

VOL. 10 NO. 4 2009 JOURNAL OF INVESTMENT COMPLIANCE PAGE 61

efcient for the market as a whole for States B, C and D to implement similar regulation, from the point of view of the regulators in those states, it is costly. To the extent possible, regulators in States B, C and D will instead free-ride on the innovative regulation enacted in State A. So, in actuality, this aspect of state-based regulation is more likely to stall regulatory innovation than promote it. Proponents of state-based regulation argue that it enhances regulatory efciency. But these arguments fail to consider the external forces that inuence state regulators. Because state regulators are maximizers, the external forces that inuence them often take precedence over efciency in regulatory decision-making. Accordingly, I contend these external forces serve as additional evidence against New Yorks proposal to subject covered CDS to state-based regulatory oversight.

IV. Conclusion
Our recent economic crisis has highlighted the important role economic regulation plays in our nancial markets. The divergence between private and socially optimal strategies increases systemic risk and leads to market failure. The rapid deregulation of the derivatives market in the late twentieth and early twenty-rst centuries created a market that incentivized the very behavior CDS regulation ought to proscribe. Market participants on both sides of the CDS transactions faced incentives to ignore the risk inherent in free CDS transacting. The result was the worst market failure since the Great Depression. The especially destructive role CDSs played in our recent economic disaster has led to radically differing regulatory proposals at both the state and federal levels. The State of New Yorks proposal would bring a large portion of the CDS market under the umbrella of traditional state-based insurance regulatory oversight. This decision is ill advised for several reasons. Although CDSs resemble insurance contracts in many respects, they are also uniquely complex nancial instruments that are continually changing and thus not well suited for the antiquated state-based system of insurance regulation. Furthermore, the external forces that inuence state-based regulatory decision-making are likely to produce inefcient regulation. As an alternative, I propose that regulators should postpone such drastic regulatory reform and instead provide market participants with an opportunity to regulate for themselves. Because of the information market participants maintain, voluntary mitigation of transaction costs is far more efcient than any prospective mitigation to be attained through regulation (see Shadab, 2009, p. 36). Consistent with this hypothesis is the fact that since the AIG debacle, companies trading in CDSs have improved risk management practices generally and collateral usage is increasing (see Shadab, 2009, p. 35). This indicates that market participants have taken it on themselves to internalize transaction costs voluntarily, thus rendering an especially burdensome state-based regulatory framework unnecessary. The debate regarding regulation of CDSs is likely to continue and subsequent regulation is sure to follow. However, any regulatory oversight that is to be implemented should not be exercised at the state level.

Notes
1. See Werrett (2009) (stating that these lending practices created a situation in which half of the nations [home]buyers were a short downturn in the market from owning more on their homes than the home was worth.). 2. See Circular Letter No. 19, State of New York Insurance Department (September 22, 2008), available at: www.ins.state.ny.us/circltr/2008/cl08_19.htm 3. Valuing, as of mid-2007, the US stock market at $22 trillion and falling; the US treasuries market at $4.4 trillion; and the mortgage market at $7.1 trillion. 4. See Part III below.

PAGE 62 JOURNAL OF INVESTMENT COMPLIANCE VOL. 10 NO. 4 2009

5. For a more in-depth discussion of The Problem of Social Cost and the Coase Theorem, see Zolnor (2009). 6. See Beville (2009) (stating, systemic risk can be generally dened as the risk that a negative shock to a rm or asset will result in losses or failure across the nancial system.). 7. See Sjostrom (2009) (stating, [c]ounterparty risk is the risk that a protection seller will be unable or unwilling to make the payment due under a CDS following a credit event.). 8. For an example of the incentives market participants on both sides of the transaction faced, see Part II.C.ii infra, and the discussion regarding the regulatory capital relief that CDS provided buyers. 9. See Hazen (2009), p. 7) (stating that ill-advised rational for the absence of regulation was that the market would act as its own regulator.). 10. See [3] p. 7. 11. Forrester et al. (2009) (The State of Missouri and the Task Force on Credit Default Swaps of the National Conference of Insurance Legislators have both proposed legislation similar to New Yorks proposal). 12. See Part II.C.ii above. 13. See Florida Insurance Commissioner McCarty Says: Leave Insurance Regulation to the States, Florida Ofce of Insurance Regulation Media Release, September 24, 2008, available at: www.oir. com/PressReleases/viewmediarelease.aspx?ID 3026 (citing a speech given by Kansas Insurance Commissioner and National Association of Insurance Commissioners President Sandy Praeger). 14. See Part II.A, below. 15. See Baker v. Selden, 101 US 99 (1879)(holding that a fundamental principle of copyright law that a copyright does not protect an idea, but only the expression of that idea). 16. See for example Computer Assocs. Intl, v. Altai, 982 F.2d 693 (2d Cir. 1992)(where the court was forced to create a new substantial similarity test for software infringement); See also A&M Records v. Napster, 239 F.3d 1004 (9th Cir. 2001)(where the court confronted the issue of whether peer-to-peer le sharing software constituted vicarious or contributory copyright infringement); See also MGM Studios v. Grokster, 545 US 913 (2005)(where the court was asked to determine the copyright liability of a distributor of a product capable of both lawful and unlawful use for acts of infringement by third parties using that product). 17. These novel forms of IP protection include software patents, open source software licensing and the like. 18. NY Ins. L. 3401. See Hazen (2009, p. 13). 19. See Baher (2005), ([The] value of federalism is that it promotes the democratic ideal because state governments are more closely in tune with their citizens and therefore more accountable and responsive to local constituent needs.). 20. See for example, Grace and Phillips (2007, p. 234). (stating our results suggest the state-by-state nature of insurance regulation provides individual regulators with reduced incentives to regulate their domestic industry and increased incentives to divert the savings to activities that maximize the private benets of the regulator.).

References
Abbott, F.M., Cottier, T. and Gurry, F. (2007), International Intellectual Property in an Integrated World Economy, Aspen, Gaithersburg, MD, p. 413. American International Group, Inc. (2008), 2007 Annual Report (Form 10-K) 3 (Februrary 27, 2008), available at: http://idea.sec.gov/Archives/edgar/data/5272/000095012308002280/y44393e10vk.htm Baher, A. (2005), Squaring the predatory lending circle, Florida Law Review, Vol. 57, p. 300, 391. Baker, T. (2003), Insurance Law and Policy: Cases Materials and Problems, Aspen Law & Business, New York, NY, p. 139.

VOL. 10 NO. 4 2009 JOURNAL OF INVESTMENT COMPLIANCE PAGE 63

Besley, T. and Case, A. (1995), Does electoral accountability affect economic policy choices? Evidence from Gubernatorial term limits, Quarterly Journal of Economics, Vol. 110, p. 769. Beville, M. (2009), Financial pollution: systemic risk and market stability, Florida State University Law Review, Vol. 3, available at: http://ssrn.com/abstract 1265886 Coase, R.H. (1960), The problem of social cost, Journal of Law and Economics, Vol. 1. Falaschetti, D. and Orlando, M.J. (2008), Foundation, in Money, Financial Intermediation, and Governance, Edward Elgar, Aldershot, pp. 15-24. Fineout, G. (2009), Big insurer says it will quit Florida property market, NY Times, January 27, available at: www.nytimes.com/2009/01/28/us/28orida.html?_r 1&scp 13&sq charlie crist&st nyt Wall Street Journal Review and Outlook (2009), Floridas unnatural disaster, 4 February, available at: http://online.wsj.com/article/SB123371173559046209.html Forrester, J.P., Telpner, J., Parker, E., Hamilton, L. and Piracci, J. (2009), Proposed Reform of the OTC Derivatives Market: Turning Weapons into Plowshares?, The Journal of Structured Finance, Vol. 15 No. 2, pp. 9-19. Grace, M.F. and Phillips, R.D. (2007), The allocation of governmental regulatory authority: federalism and the case of insurance regulation, Journal of Risk and Insurance, Vol. 74 No. 1, pp. 207, 208-209. Hazen, T.L. (2009), Filling a regulatory gap: it is time to regulate over-the-counter derivatives, North Carolina Banking Institute, Vol. 13, pp. 123-34, available at: http://ssrn.com/abstract 1338339. Morrissey, J. (2008), Credit default swaps: the next crisis?, Time, 17 March, available at www.time. com/time/business/article/0,8599,1723152,00.html Peltzman, S. (1976), Toward a more general theory of regulation, Journal of Law & Economics, Vol. 19 No. 2, pp. 211-40. Poterba, J.M. (1994), State responses to scal crisis: the effects of budgetary institutions and politics, Journal of Political Economy, Vol. 102 No. 4, pp. 799-821. Shadab, H.B. (2009), Guilty by association? Regulating credit default swaps, Entrepreneurial Business Law Journal, Vol. 2, available at: http://ssrn.com/abstract 1368026 Sjostrom, W.K. (2009), The AIG bailout, Washington and Lee Law Review., Vol. 66 10 March, p. 943, available at: http://ssrn.com/abstract 1346552 State of New York (2008), Governor Paterson announces plan to limit harm to markets from damaging speculation, September 22, available at: www.state.ny.us/governor/press/press_0922081.html Stulz, R.M. (2009), In defense of derivatives and how to regulate them, The Wall Street Journal Opinion Journal, 6 April, available at: http://online.wsj.com/article/SB123906100164095047.html Teather, D. (2008), The woman who built nancial weapon of mass destruction, September 20, available at: www.guardian.co.uk/business/2008/sep/20/wallstreet.banking Tennyson, S.L. (2007), Efciency consequences of rate regulation in insurance markets, Networks Financial Institute Policy Brief No. 2007-PB-03, 2 (2007), available at: http://ssrn.com/abstract 985578 Werrett, J. (2009), Back to the basics of mortgage reform: centralized regulation, capital reserves, and adequate insurance, Connecticut Law Review, Vol. 6, available at: http://ssrn.com/abstract 1367765 Zolnor, M.A. (2009), Internal control reporting regulation: a law and economics perspective, Journal of Investment Compliance, at Part II.A, Vol. 10, available at: http://ssrn.com/abstract 1372386

Corresponding author
Matthew A. Zolnor can be contacted at: mzolnor@gmail.com

To purchase reprints of this article please e-mail: reprints@emeraldinsight.com Or visit our web site for further details: www.emeraldinsight.com/reprints

PAGE 64 JOURNAL OF INVESTMENT COMPLIANCE VOL. 10 NO. 4 2009