Credit Default Swaps: Bad Enough to Ban?

The federal government's aggressive actions to protect the financial system, including a plan to invest $250 billion in preferred equity stakes in major banks like Goldman Sachs (GS Quote), Morgan Stanley (MS Quote), JPMorgan Chase (JPM Quote) and Citigroup (C Quote), suggest that strings will be attached in the form of stricter laws, although we haven't yet had much of a taste of what those laws might be.

That may be why the threat to ban CDS has caught Wall Street totally unprepared. The financial industry's chief lobbying arm in this area, the International Swaps and Derivatives Association, seems unable to bring itself to admit the need for any regulation at all. Ask ISDA if it supports regulation, and it doesn't provide a clear yes-or-no answer.

"ISDA continues to support the development of options for participants in the credit derivative markets to undertake their business in the most prudent and efficient manner and to the highest standards of commercial conduct," the trade group says in an emailed statement.

"ISDA is not the most constructive force in all of this," says John Coffee, a law professor at Columbia University.

The Wall Street trader agrees. "Congress is swinging all the way in one direction with a pendulum, the Street is saying 'no regulation,' and we're going to end up in the wrong place," he says. "We're going to have to work together to come up with good regulations."

CDS are unregulated, privately negotiated contracts that allow creditors to insure themselves in the event that their borrower defaults. But the derivatives have also been used for speculative purposes -- these are known as "naked" CDS, in which third parties trade the derivatives as a way of betting on the health of a given company or, in some cases, a basket of securities.