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FROM THE COMMENT SECTION of the article you posted-—>>>

This is a snippet from a piece by Hutchinson at The Prudent Bear. The whole thing explains quite clearly how this got out of hand AND how to fix it. His point is that the thing wasn’t “irrational” at all. It was rational as insurance companies selling life insurance policies for complete strangers (There was money in it, after all) only to watch the homocides spike on the insured victims. Something had to be done and it was. The same applies now for derivatives. Expecting traders to have a conscience is unrealistic:

In the early years of the London insurance market, it was possible to buy a life insurance policy on a complete stranger. Then insurance companies noticed the high incidence of unexpected homicides among their lives assured, and the concept of insurable interest was devised, codified by the Life Assurance Act of 1774. Today, you can’t buy a life insurance policy unless you can demonstrate some loss by the assured party’s death. The business is safer that way!

The same consideration must surely apply to the CDS market. The legitimate hedging purpose of CDS today represents only a tiny proportion of contracts outstanding. The U.S. taxpayer is already on the hook for $150 billion, with more to come, through the inept CDS operations of the insurance behemoth AIG. With multiple bankruptcies and huge market instability owing at least part of their provenance to CDS, the public policy consideration for closing or at least sharply restricting the CDS market is even clearer than that promoting the restriction of the insurance market in 18th century London (at least taxpayers weren’t expected to pick up the tab for insurance policies on murder victims!)

As a minimum, therefore, CDS writing should be restricted to those holding bond, loan or swap obligations against which CDS might reasonably hedge. CDS should be distinguished from stock short positions and stock options (which have similar theoretical possibilities) because their greater leverage and higher outstanding volume make them uniquely dangerous. Such a market would be highly illiquid, but it would fulfill CDS’s essential function of enabling credit risk transfer. CDS’s other advantages, of demonstrating credit spreads over a public marketplace, allowing the hedging of baskets of similar credits, providing an instrument for hedge fund “investment” and making huge returns for the major dealers, would be lost. However, CDS’s destabilizing effect on global financial markets would also be lost, and the cost to taxpayers of rescues for those major institutions which had either got the CDS market wrong or were victims of CDS “bear raids” would be eliminated.

The free market is a wonderful thing. However, allowing unrestricted free markets in everything, without regard to the real-world economic effect of those markets, is a Whig shibboleth similar to the “Repeal the Corn Laws” unilateral free trade policies that destroyed Britain’s economic strength in the 19th century. The great and economically highly sophisticated Tory Prime Minister Robert Lord Liverpool, a generation prior to the mid-century free traders, also believed in free markets, but was a realist in their application to the world in which he lived.

The real world is messy and does not conform to simplistic equations either mathematical or moral. The wise policymaker will legislate accordingly, providing the maximum market freedom but inserting restrictions where the temptations to malfeasance are too great. The CDS market forms an open and shut case for restrictive regulation.