Producto: Plan Ahorro Generacional

To reduce the risks of credit derivative hedges, regulation

could also seek to decrease the level of activity associated with these

types of transactions. One way to accomplish this would be to limit

recognition of certain CDS and CDO transactions as hedges. As a

starting point, regulators could classify as a hedge only cleared or

exchange-traded credit derivatives. This would deny preferential

regulatory treatment for OTC credit derivative hedges, encouraging

firms to move as many of their hedges to clearinghouses or central

exchanges. This classification would comport with the goals of the

Dodd-Frank Act of moving as much derivatives trading as possible

to exchanges. Another approach would be to deny hedge recognition

to illiquid credit derivatives and/or credit derivatives used for

portfolio hedges. This approach creates a narrower category of

transactions that would not qualify for the hedge exemption,

focusing on those that are on balance most likely to be more risky

than beneficial.

Either proposal would enhance regulatory oversight of the

types of hedging transactions that are most likely to be accompanied

by hidden risks. Such limitations would not prevent firms from

hedging—either with illiquid credit derivatives or with credit

derivatives for portfolio hedging. Firms can choose to use a more

liquid credit derivatives or hedge risks on a micro, rather than macro,

level in order to have the transaction classified as a hedge.

Alternately, they could use these transactions to hedge, but these

transactions would not be deemed a hedge for regulatory purposes.

This alternative places the need for market stability above the firms’

individual needs to use certain instruments or strategies to address

their risk exposure.

Yet another alternative to restrict credit derivative hedge

activity is to impose position limits on credit derivative hedges.

Position limits have been considered solely in terms of their ability to

minimize market manipulation by speculators.

However, position

limits may also have a useful role in limiting the reach of a failed

credit derivative hedge transaction. Through position limits,

regulators can address the risks that arise from using credit

derivatives to hedge.

_{By employing position limits in this manner,}

the fallout of a failed hedge would be cabined significantly, as it

would reduce the exposure of hedgers and other market participants

to certain hedge transactions.

Notably, hedge position limits would limit the exposure of a

firm to codependent risk, particularly with portfolio hedges, by

limiting the size of an outstanding position in credit derivatives used

to hedge. Further, if limitations were imposed on these instruments

used to hedge, in the event that a firm falls victim to codependent

risk, the resulting negative consequences would be minimized. This

limitation is similar to the Dodd Frank Act’s requirement that banks

maintain a portion of mortgages they have originated on their

books.

_{Moreover, imposing limitations on credit derivative-based}

hedges would minimize the negative consequences in the event a

firm falls victim to codependent risk. Similarly, position limits would

also limit the consequences of a hedge that exposes a firm to

counterparty credit risk and convergence risk.

Given that hedging is beneficial, position limits should not

apply across the board to all hedge transactions. Instead, position

limits for hedgers should be higher than position limits for

speculators. This would respect the fact that the reasons for imposing

hedge position limits are not the same as the reasons for imposing

speculative position limits. Also, this would recognize that hedging

can be beneficial and should be encouraged. Finally, hedge position

limits should not apply to one-to-one credit derivative hedges and

CDS or CDO hedges traded on an exchange or cleared. These types

are less likely to have systemic implications or raise the concerns

pertaining to credit derivative hedging discussed throughout this

Article.

However, position limits, even for speculative positions, face

strong market objections and may be politically impossible for

Seesupra Part II.B.

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Seesupra Part II.B.

agencies to impose.

Such objections would likely be even stronger

for subjecting hedges to position limits. One of the main objections

is that hedge position limits would have a chilling effect on hedging.

Hedge position limits, the argument goes, would discourage firms

from entering into beneficial hedges because of higher transactional

costs or, worse yet, may encourage regulatory arbitrage, as firms

would search for less regulated means to neutralize their risk

exposure. However, regulating hedging is not the same as preventing

hedging. This Article proposes the former, not the latter. Further,

because of the importance of hedging to corporate risk management

strategies, it is unlikely companies will abandon hedging because of

restrictions. Indeed, firms may be more conscientious in exposing

themselves to credit risk knowing that their ability to offset these

risks will be legally limited.

The fact that regulation chills activity, whether intentionally

or unintentionally, while a legitimate objection, is an argument that

may be leveled against the adoption or imposition of most rules. As

some academics have opined, the financial markets are similar to the

tragedy of the commons,

_{in that each actor seeks to reap maximum}

benefits from finite resources, without regard for the resources’

depletion. In order to prevent or reduce the likelihood of complete

exhaustion of these finite resources, laws need to regulate each

actor’s use of the resources in order to maximize the common good.

Imposing hedge position limits to circumscribe the possible fallout of

a bad hedge is one of the best ways to ensure that market participants

are able to share in the finite resources of the “financial markets

commons.”