Why is New York moving to regulate a complicated part of the derivative market? Because no one else was keeping an eye on it.
That was the message from the state's top insurance regulator.
"What shook the world, what blew up the economy, is what we chose not to regulate, and we chose not to regulate $60 trillion of financial instruments," New York State Insurance Superintendent Eric Dinallo explained on CNBC Wednesday.
"This is not a land grab. This is us saying, the part that we can do is the part that's an insurance policy, indisputably. I don't think anyone disagrees that the transaction that we're discussing is an insurable interest." (See his full interview in the video)
New York's Governor David Paterson earlier in the week announced new regulation would begin in January for credit default swaps that serve as insurance. New York's banking department is working with the Federal Reserve Bank of New York to help create a central clearing house for credit default swaps. (Read more about regulator moves on credit default swaps here)
The move marks the third clearing house being planned for the credit derivative market. A clearing house is viewed as crucial to removing risks posed by the failure of a large counterparty, as it would step into the middle of all trades.
"It's not insider trading, it wasn't market timing or late trading, it was what we chose not to regulate," Dinallo explained.
"It's sort of like AIG writ large. When you peeled back AIG and you went inside, there was the solvency behind the insurance policies, there was real capital there, that's what permitted the Fed to do the transaction, and then there was everything else, the CDSs and uncovered securities transactions. I think a similar market is going to develop."
"What the governor is talking about here is taking what has worked before for some percentage of the market -- insurance regulation has worked extremely well through this financial crisis because the main obsession of insurance regulators is to make sure there's solvency behind the commitments. This $50 trillion that is uncovered, that is naked CDS, necessarily has no capital requirements...what he's talking about is applying the solvency that insurance regulations and laws have brought, and the state regulators have done a fabulous job on that, you can see it through AIG, and they would take that and say that for these, there's solvency there. For the rest, it has to be discussed."
"The thinking was, that if it was a credit default swap that did not require you to show proof of loss, that therefore it was not something that you need to ask about whether it was insurance, because you didn't have to show that you actually lost, whether you actually owned the bonds or not. That was the intellectual distinction, but I think the governor's way is the better way."
Reuters contributed to this report.