Liveblog: CDS- Misunderstanding?

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Commissioner Peter Wallison is suggesting that Credit Default Swaps are not inherently problematic. We just don’t understand the underlying principles, he tells the witnesses. Wallison is asserting that CDS are just loans under another name, and if society and financial firms come to understand CDS everything will be fine.

Gary Gensler, Chairman of Commodity Futures Trading Commission, correctly points out however, that a CDS and a loan are fundamentally different. With a loan, principal must be put forth at the beginning of the transaction. That is to say that AIG would have had to put up hundreds of billions of dollars in principal if its CDS were just loans. But of course, CDS are not loans, and capital isn’t required in the same sense.

Dinallo elaborates on Gensler’s comments, reminding everyone that introducing to Wall Street a financial instrument that does not require capital invites financial firms to leverage up and adopt unreasonable amounts of risk. Indeed, CDS are uniquely different from financial instruments that the economy has seen before, and the regulatory framework was simply not in place to provide proper guidance to firms dealing with such a volatile instrument.

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