Testimony on the Credit Crunch

featuring Darrell Duffie
Wednesday, July 9, 2008

Questions for the Hearing on “Reducing Risks and Improving Oversight in the OTC Credit Derivatives Market”

Questions for Dr. Darrell Duffie, DeanWitter Distinguished Professor of Finance, from Senator Crapo, with Responses:

  1. Should market participants have the broadest possible range of standardized and customized options for managing their financial risk and is there a danger that a one-sizefits- all attitude will harm liquidity and innovation?

    Response: A one-size-fits-all approach would indeed harm innovation. Standardization allows simpler methods for mitigating some of the market infrastructure problems that we have experienced, through easier trade documentation, clearing, and settlement. The appropriate degree of standardization, however, involves a tradeoff with the benefits of innovation and customization to customer needs. Generally, I believe that the markets should be left to determine how much standardization is appropriate. The safety and soundness of financial markets can be regulated more effectively, in my view, by other methods than mandating standardization of financial contracts.

  2. Is there a danger that centralizing credit risk in one institution could actually increase systemic risk?

    Response: The centralization of risk in one institution, such as an exchange or a central clearing corporation, could increase systemic risk if that central institution is not carefully designed and well capitalized. One approach to centralizing credit risk, exchange-based clearing, has proven to be extremely safe over many decades, including through a number of serious financial crises. A central clearing counterparty for the over-the-counter derivatives market could be essentially as safe as exchange-based clearing if it is similarly well designed and backed by significant capital or guarantees. So long as the institution into which risk is centralized performs as designed, it will reduce systemic risk, because it reduces the average level of exposure of counterparties to each other. The performance of a risk-centralizing institution is absolutely critical, however, for if it experienced a failure, the systemic effects could be grave. Because systemic risk is a cost borne by the public for which no single financial institution bears responsibility, there is a natural and important role for regulation in monitoring the careful design and ongoing safety of risk-centralizing institutions.

Read the full transcript:duffiesenatecreditderivativesqanda2008.pdf