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Originally Posted by ERD50
This is the main reason I am on such a "less government" kick.
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But in the case of CDS it was a failure caused by a lack of government intervention. The original idea was that the government shouldn't get involved in bi-lateral contracts between sophisticated institutions (which is what Credit Default Swaps are). Sounds very reasonable and something I certainly would have supported at the time.
The problem was that these "sophisticated" institutions did a lousy job of managing their counterparty exposure to one another and allowed massive systemic risk to build in the system. Everyone assumed that market driven survival instincts would make sure everyone managed their own liabilities. Unfortunately, it didn't happen that way. Which is one of the things Allan Greenspan issued a mea culpa over.
The beauty of an exchange based system is that every contract is cleared through a single counterparty so that every short is matched off against its long. Daily collateral postings for any net liabilities keeps credit risk to a minimum.
The reason it wasn't set up this way to begin with was because financial institutions prefer the less transparent over-the-counter market. There is huge money to be made by broker dealers in markets where they have an information advantage. It was good for them while it lasted (or so they thought).
Had government mandated that these products be traded on an exchange from the very beginning, this part of the problem would have been averted.
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