The CDS market is useful, but not perfect

I've defended the credit default swaps (CDS) market many times before, but even I wouldn't endorse this proposal from Harvard's Oliver Hart and the University of Chicago's Luigi Zingales. Under their proposal, capital requirements at large financial institutions (LFIs) would be subject to a sort of "margin call" on equity holders in LFIs, which would be triggered when the CDS spread on a given LFI rises above a predetermined threshold. Hart and Zingales explain how it would work:

[A]n LFI will have to post enough collateral (equity) to insure that its liabilities are always paid in full. When the fluctuation in the value of the underlying assets puts creditors at risk, the LFI's equity holders will be faced with a margin call: They will either have to inject new capital or lose their equity. In both cases the creditors will be protected.
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In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI to issue equity until the CDS price and risk of failure back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.

Hart and Zingales put way too much faith in the accuracy of CDS spreads. It's true that the CDS market is more liquid than the corporate bond market—that's one of its main attractions. But the CDS market is still much too thinly-traded, and liquidity in single-name contracts is still much too spotty and unreliable, for something as important as capital requirements at major financial institutions to be based on CDS spreads.

What's more, liquidity decreases as the spread rises, so the closer the CDS spread gets to the margin trigger in Hart and Zingales's proposal, the less reliable the spread becomes. The pricing mechanism in the CDS market isn't exactly a model of transparency either—pricing services like Markit just use quotes provided by dealers.

Since single-name CDS on financials are relatively thinly-traded, any of the dealer banks could push the CDS spread on an LFI up past the threshold (wherever it may be), forcing a "margin call," without even using too much of its balance sheet. Hell, a decent-size hedge fund could push the CDS spread on an LFI up past any threshold level if it really wanted to. For traders at the dealer banks, this would be like hunting squirrels with a bazooka.

The CDS market is an extremely useful tool, and recent changes are all to the positive. But let's not get carried away.