Monday, April 12, 2010

Kristin Johnson on the Institutional Structure of Credit Default Swap Markets

Lin Ostrom alerted me to an interesting looking working paper by Seton Hall Law Professor Kristin N. Johnson, "Things Fall Apart: Regulating Credit Default Swaps in the Battle of Man vs. the Gods of Risk." Here is the abstract:
Financial markets provide an invaluable national and international infrastructure resource that reflect attributes similar to a commons, as described in property law literature. The story of credit default swaps illustrates this analogy. Traded in an openly accessible, non-rival and nonexcludable market, credit default swaps engender important economic benefits. Abuse of the market creates negative externalities that are not internalized by market participants; rather, the costs are borne by society. Commons scholars’ empirical research suggest that community rule-making and policing offers the most effective reform to sustain the desirable resource. This Article proposes the creation of a federally registered self-regulatory organization (SRO). To ensure that the SRO adopts sufficient checks and balances to monitor systemic risk, this Article suggests that a council of domestic federal agencies retain supervisory authority over the credit default swap SRO. Finally, this Article posits that collaboration among international securities regulators is imperative for any noteworthy victory in the battle against the gods of systemic risk.

Johnson's treatment of the credit default swap market as a kind of commons is intriguing, as is her recommendation of federally registered self-regulatory organizations to minimize risks of systemic market failures. What I missed, however, was a nuanced assessment of design principles for predicting when such SROs might fail or succeed over time. In her groundbreaking 1990 book Governing the Commons (Cambridge), Elinor Ostrom noted that common property regimes fail about as often as they succeed at sustaining common pool resources (CPRs) over time; and she offer "design principles" for predicting success and failure. Unless Johnson expects SROs to be always successful, which (a) seems doubtful and (b) would vitiate her analogy to CPRs, then she needs to develop a similar testable model.

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