Vol 6 (2009) - Issue 4

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The Milgram Universe of Credit Derivatives: A Regulatory Proposal – Part One

1. Introduction

Much work in social psychology suggests that in compressed and interactively complex systems, subjects surrender responsibility for their actions in full faith of the system. The leading experiment on obedience, the Milgram experiment, was originally devised by Stanley Milgram to test the willingness of subjects to comply with acts against their conscience under the instruction of authority. However, his later findings, and further research by other academics have expanded the scope of his previous conception of ‘authority’ to hospital studies, aviation, and business contexts. No research has yet been conducted as to the relation between Milgram’s theory and the financial markets. This is to be regretted, for it is suggested in the course of this article that there are strong parallels.

This article is part of a two-part series intended to introduce a version of Milgram’s theory to synthesise and develop the issues surrounding the credit derivatives market in Europe. The first part of this series utilises a regulatory/psychology lens to examine the structure and characteristics of the credit derivative markets, and begins outlining a framework according to Milgram’s theory to understand and analyse these markets.

Preliminary clarifications are also made in this process, to challenge the sustainability and accuracy of this framework. In the second part of this series, this analysis will be continued to test the supposed correlation of credit derivatives with the recent credit crisis, and this article will suggest a regulatory proposal for securities markets ahead under the aegis of the Milgram framework, not limited to credit derivatives.

Credit derivatives are the main credit risk transfer instruments. Financial institutions use them for a variety of functions, including hedging credit risk, trading/ market making, and attaining tax relief.7 According to the International Swaps and Derivatives Association (‘ISDA’), the main private body that regulates derivative contracts, the notional amount outstanding of credit derivatives amounted to USD 54.6 trillion on 24 September 2008. ISDA’s model contracts and definitions are the standard contractual documentation for the majority of financial participants, including over 820 member institutions from 57 countries. Currently, credit derivatives remain in the ambit of private contracts, and are executed in the over-the-counter (‘OTC’) market, though a move to European Union central clearing will take place in July 2009.