Regulating Credit Default Swaps Is No Answer

Turn on C-SPAN these days and you hear hour after hour of Congressional debate as politicians who couldn't differentiate a stop-loss order from a snowmobile opine on the dangers and pitfalls of financial instruments that most of them obviously know nothing about.

The chief culprit right now is the "credit default swap," a type of insurance against default, regularly portrayed as cyanide or dynamite. In reality, it is anything but.

Trade is mutually beneficial, which is exactly why market participants engage in it. When it comes to swaps, some investors were hedging risk, others wanted to speculate, but all were acting legally, lawfully and within their own self-interest. Nobody's rights are harmed when two willing parties engage in voluntarily trade. As we've documented many times since the Bear Stearns bailout, the chaos now seen in the financial markets is a direct result of government intervention, not an unregulated free market.

Yet still more regulation, for insurance, banking, credit, hedge funds and yes, the nefarious credit default swap, is imminent, even as politicians scurry to account for how $165 million in bonuses were paid at a company they already control.

Credit default swaps might seem dangerous and complicated, but it wasn't too long ago when simple stock options — calls and puts, were seen in much the same light. Although they are virtually ubiquitous now, the listed options market was only born about 35 years ago, when the Chicago Board Options Exchange opened on April 16, 1973.

That first day a whopping 911 contracts traded — all calls, because put contracts had not yet been approved by regulators fearful they could artificially depress stock prices. (Call options give the option buyer the right to purchase stock at a predetermined price on a certain date while put options give the option buyer the right to sell shares at a certain price on a certain date.) So you could bet on the market going up, but not down. Sounds a bit like the disastrous short-selling ban last year.

After repeated delays by the SEC, trading in puts finally began, on five stocks, in 1977, a full four years later. Even as trading grew rapidly, the SEC at that point imposed two-year moratorium halting the listing of all additional options pending additional review.

Today we understand that buying a put doesn't cause a stock to fall and that options are simply a tool investors can use to manage their portfolios. The rush to scapegoat one particular instrument ignorantly suggests that trade is destructive and that businesspeople, if not for the wise counsel of government bureaucrats, would slit their own throats. Makes great headlines, but it simply isn't true.