The Bankers Know Best: How Regulatory Policy Shaped the Rise and Fall of the Credit Default Swap Market

Abstract

Many critics partially attribute the severity of the 2008 financial crisis to a lack of regulatory oversight over credit derivatives. This paper will examine the governmental and private regulatory systems that aided the proliferation of these complex “financial weapons of mass destruction” and the ideological underpinnings that blinded users and regulators alike to their destructive power, focusing on credit default swaps (CDS), the most common credit derivative. Motivated by a desire to foster market growth and emboldened by their faith in financial innovation and the power of markets to self-regulate, public officials largely left the finance industry to its own devices. With that freedom the industry put in place structures that allowed the market to flourish. That is until an economic shock, in the form of a decline in housing prices, crippled an industry built on a foundation hollowed by its neglect of systemic risk.