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.
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.
Although CDSs resemble insurance contracts in many respects, they are also uniquely complex financial instruments that are continually changing and thus not well suited for the antiquated state‐based model of insurance regulation. Furthermore, the external forces that influence state‐based regulatory decision‐making are likely to produce inefficient regulation.
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 York's proposal is ill advised.
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.
