Things Fall Apart: Regulating The Credit Default Swap Commons

Kristin N. Johnson

Financial markets are an important national and international infrastructure resource that reflect attributes similar to the those that characterize commons, as described in property law literature.  Through a case study examining the credit default swap market, this Article illustrates the analogy between financial markets and a traditional commons.  After exploring the attributes of a commons, this Article examines the costs and benefits of the credit default swap market. Similar to a traditional commons, tragedy in financial markets occurs when market participants capture benefits while imposing the costs or negative externalities from their activities on other members of society.  Commons scholars’ empirical research suggests three traditional approaches to tragedy in a commons—deregulation, privatization, and regulation by a central, external authority.

This Article argues that the adoption of an alternative regulatory model—a community governance model—offers a better approach to  regulation in the credit default swap market.  Pursuant to the institutional design principles of the community governance model, this Article proposes the creation of a federally registered self-regulatory organization (“SRO”).  Finally, this Article examines the reforms recently adopted in the Dodd-Frank Act.  While significantly enhancing transparency and reducing operational, counterparty, and credit risks, the highly-anticipated reform fall short of its promise.  A better governance model would introduce agile, comprehensive institutional reforms that enable rather than restrict regulators and would create an SRO exercising regulatory authority to adapt rapidly to address known and emerging risks in the credit default swap market.