The Rush to Regulate Credit Default Swaps

It seems like politicians, regulators and even the average Joe on the street now knows something about credit derivatives. These complex instruments are being blamed for the near meltdown in the financial system. No one outside of the credit markets paid much attention to credit default swaps or CDS until they threatened Bear Stearns and Lehman Brothers.On Monday, New York State Governor David Patterson said his state had the authority to regulate part of the credit default swap market and would require issuers to register as insurance dealers. Patterson told the media that his state's insurance department would regulate CDS as insurance products in cases where the buyer of the derivative owns the underlying bond.

But the chorus of voices recommending increased regulation of credit default swaps has been growing in recent days, following the bankruptcy of Lehman Brothers, the fall of Fannie Mae and Freddie Mac and the bailout of AIG.

On Tuesday, SEC Chairman Christopher Cox called for giving the agency the authority to regulate credit default swaps. Testifying before the Senate Banking Committee on the turmoil in U.S. credit markets, Cox told Congress "the $58 trillion notional market in credit default swaps- double the amount outstanding in 2006 - is regulated by no one."

Right now these over-the counterderivatives are not traded on an exchange, and are not regulated by any of the traditional regulators- such as the SEC or CFTC. "Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market," Cox told the Senate.

It's believed that the credit derivatives market contributed to the fall of Lehman Brothers and AIG, as the cost to buy protection against a bond default surged and pushed down their stock prices.

But the real danger is that brokers and hedge funds were apparently using credit default swaps to speculate on which financial trading counterparty would default next. They could sell the CDS without owning the underlying bond on which it was based. "Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS," said Cox in his speech. "This means CDS buyers can 'naked short' the debt of companies without restriction."

Some traders used the credit default swaps to bet on the likelihood of default in the bonds of their trading counterparties, namely Lehman Brothers, AIG and Morgan Stanley. As the cost of buying protection against holding the bonds of banks and brokers surged, traders used that as a signal to short the stocks, which caused the credit agencies to lower their ratings, thereby raising the cost of capital for these companies and sending them into a cash crunch and death spiral. The SEC is concerned that credit derivatives were used to manipulate the pries of securities companies and drive them out of business.

As part of its stepped up enforcement efforts, Cox told Congress, the SEC is conducting a sweeping investigation of market manipulation of financial institutions, focused on broker-dealers and institutional investors with significant trading activity in financial issuers and with positions in credit defaults swaps. It would be easier to conduct the investigation if these instruments were traded electronically on a centralized exchange. But CDSs are for the most part traded over-the-counter, between dealers, banks and asset managers. On the dealer side, Creditex, a business that was owned by the dealers and recently sold to the InterContinental Exchange (ICE) offers an execution platform for use by the dealers.

It's clear that regulators are now focusing on the need for oversight and transparency in credit derivatives. Usage of CDS has grown dramatically among traditional asset managers and hedge funds, which means they are exposed to the counterparty risk of the investment banks that sold them protection. No doubt, there will be renewed calls for trading credit derivatives on exchanges, which can work for standardized, highly liquid contracts, and for a central clearing counterparty. But what will happen to the more customized instruments, known as bespoke instruments? In a research note published this week, TowerGroup's Senior Research Director for Investment Management, Dushyant Shahrawat, predicts, "Brokerage firms burned by OTC derivatives like credit default swaps and other esoteric structured products will greatly reduce their involvement in these instruments." Despite resistance from the dealers, Bloomberg reported yesterday that credit swaps could move to an exchange in order to exist.

In the meantime, politicians are learning more about these instruments and forming quick opinions. Patterson told The New York Times he had not heard of credit default swaps until he read an article in The Economist six months ago. He said he thought they should be regulated by the gaming industry and he equated the derivatives with gambling.

Here's a link to the NYT article

Here's a link to the Bloomberg storyOn Tuesday, SEC Chairman Christopher Cox called for giving the agency the authority to regulate credit default swaps. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio