In 2016, the Federal Reserve proposed a new rule that would limit how exposed a large bank could be to the risk of counterparty default by another large bank. At the same time, a report by a government agency indicated that by both buying and selling credit default swaps, banks may still be exposed to significant counterparty risk even though the use of credit default swaps had dropped by more than 75% since the financial crisis. An article in the Wall Street Journal on proposals to change the regulations governing the trading of financial derivatives contained the following:
The SEC and the Commodity Futures Trading Commission are both seeking greater authority to police the over-thecounter market and hope new powers can help them reduce the risks that over-the counter trading may pose to the broader system.
a. Why might a bank buy a credit default swap?
b. What counterparty risk exists for a buyer of a credit default swap?