Derivative Legitimacy: Credit Default Swaps and Credit Ratings Before the 2007 Financial Crisis

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  In Refereed Roundtable 100min: Table 09. Power, Perception, Risk and Discourse

Abstract

The 2007 financial crisis is often attributed to a complex global system of derivatives, yet how these market technologies became highly liquid and traded under the auspices of legitimate financial activity has remained unexplored. This paper argues that the financial innovation of credit default swaps (CDSs) became institutionalized first by appealing to a longstanding and publicly visible indicator of information, credit ratings agencies. In drawing on an established authority, old risk-assessment categories helped to translate the uncertainty of newness into tractable risks. I extend this finding, which is consistent with other work on dynamics of category emergence, to show that the initial coordinating effect of credit ratings wanes as the CDS market develops. Using a time-series approach, I argue and find evidence that dynamics of category emergence surrounding a new innovation may not persist in the long run; the initial legitimizing effect of credit ratings was sufficient to crystallize CDS market dynamics and support CDS market momentum, but ongoing market coordination found credit ratings increasingly obsolete and decoupled from underlying risks.

Author

• Sophia Li, Princeton University