To hear some people talk about them, credit default swaps are financial weapons of mass destruction. Others tend to see them as modern financial tools that can facilitate better risk management. No matter what your view, two things are clear: Derivatives such as these are here to stay and reform regulation is on the way. 

A huge battle now looms: In one corner, federal regulators who would like to create a market that would rival the stock markets in terms of transparency and regulate-ability. Wall Street on the other hand has profited enormously from trading CDSs and they are not about to give up their massive spreads and commissions without a fight. 

So in some ways, the situation reflects the stock markets before new order handling rules, decimalization and other changes made it much harder for traders to make money (the situation has reversed itself somewhat lately). In some sense, it also reflects the bond market before the end of fixed commissions. All of which is to say: We stand at the edge of a new era that threatens the profit of big Wall Street broker dealers. None of this is new. 

It's clear to all that Wall Street is digging in. In this environment, for PR purposes, it can't very well oppose reform attempts. But it can work to shape them to its liking. Wall Street's biggest broker dealers have thrown their weight behind a clearinghouse initiative spearheaded by the Intercontinental Exchange (ICE). They have all taken equity stakes and are supporting the clearinghouse with their volume. Since March, it has cleared $710 billion in CDSs. To the chagrin of competitors like the CME Group, who do not enjoy the backing of the dealers; it has yet to clear a single trade. 

So the dealers--who have banded together to form the CDS Dealers Consortium--enjoy the advantage of an existing solution. For the exchange movement to prevail, it will require some stand-up leadership. While the Treasury Department has not embraced an all-out move to an exchange, several bills have been proposed that would do just that. 

They have the benefit of recent memory. After all, these are the tools that caused the financial meltdown in the first place. Given their importance, shouldn't they be as tightly regulated and the market as closely monitored as stocks? 

Here's one area where they might make hay: Insider trading. 

The SEC charged recently a Deutsche Bank bond salesman with giving inside information about a bond issue to a portfolio manager who bought CDSs and realized an immediate profit of $1.2 million based on the information. That was the first-ever case of insider trading that involved the CDS market. Regulators have invested heavily in creating systems to prevent insider stock trading, but we've got nothing when it comes to CDSs. Would an exchange offer any more protection? 

In a different vein, Larry Tabb, of the Tabb Group, notes that one critical tool might be capital requirements. While the debate now centers on moving CDS trading to an actual exchange or instead requiring central clearing (a movement well underway), Tabb suggests that capital requirements could be deployed as a way to reduce risk across the market. 

"Regulators only need to implement a sliding capital scale depending on the product, clearing method or trading mechanics to change the way that products are developed, underwritten, traded and positioned. Naturally exchange-traded products would have the lowest capital requirements, centrally cleared products a bit higher and OTC self-cleared products would maintain the highest tariff," says Tabb. 

The nascent central-clearing movement, if I recall correctly, does require all parties facing the clearinghouse, which is to say all trading parties, are required to essentially post a bond. The idea is certainly not far fetched. We'll see how this plays out. - Jim