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Unnecessary Intervention: The Administration's Effort to Regulate Credit Default Swaps
...The most basic question anyone should ask about a new proposed regulation is this: "what problem is this proposal intended to solve?" Regulation is costly, suppresses innovation, and reduces competition, so before we impose these costs on yet another industry--and those who consume its products or services--we should at least ask why regulation is necessary.

The administration's short answer to this question would undoubtedly be "AIG"--the idea, firmly embedded in the media mind, that AIG had to be rescued because, as a major CDS market participant, its failure would have created a systemic breakdown. No one in a responsible position at the Federal Reserve ever said this publicly, and the story has now become a classic case of something having been repeated so often, in so many places, that it somehow becomes true, even though no one can trace it back to an actual fact. Perhaps the administration actually believes that regulation of CDS is necessary to prevent a systemic breakdown, but it is far more likely that the administration is proposing to regulate the swap markets because it can, following the precept of the president's chief of staff, Rahm Emanuel, who famously remarked at the outset of the administration that one "never wants a serious crisis to go to waste."

Even if Fed officials had confirmed that AIG's swap portfolio was the reason for the firm's rescue, there would still be a question as to whether that judgment was correct. Accordingly, this Outlook will start with the more basic question: could AIG's CDS portfolio--no matter its size--have caused a systemic breakdown (or even a major disruption) of the financial markets if AIG had been allowed to fail? As I will explain below, I think the answer to this question is no, and thus I doubt the need for any legislation that regulates this or any other part of the derivatives industry....

...Under these circumstances--and given the CDS market's history of stable operations over the current decade and even during the current crisis--it would not be good policy to force any CDS transactions through a clearinghouse. Because of the adverse incentives it creates for members, a clearinghouse could produce more aggregate risk than the bilateral OTC market that it would replace. Nor can it be shown that a clearinghouse will have any effect in preventing a systemic breakdown. Together, these elements suggest that the unintended consequences of requiring the establishment of one or more CDS clearinghouses seem to outweigh whatever limited benefits might be achieved by a CCP system.