From the March 01, 2009 issue of Futures Magazine • Subscribe!

No specs in CDS market

Industry insiders who hoped that Congress’ attacks on speculators in 2008 would slow down in 2009 were likely disappointed about the introduction of The Derivatives Markets Transparency Accountability Act of 2009. The legislation by House Agriculture Committee Chairman Collin Peterson (D-MN) makes it a violation of the Commodity Exchange Act to enter into a naked credit default swap (CDS), meaning that a party could not enter into a CDS contract unless it has direct exposure to financial loss, should the referenced credit event occur.

It also places restrictions on foreign boards of trade in providing U.S. participants access to their electronic trading systems, requires the Commodity Futures Trading Commission (CFTC) to provide position data on index funds and data on speculative positions, requires the CFTC to set position limits for all commodities, and requires that all prospective over-the-counter (OTC) transactions be cleared through a CFTC-regulated designated clearing organization.

On Feb. 3 and 4, industry leaders testified before the House Agriculture Committee on the bill.

Greg Zerzan, head of global public policy at the International Swaps and Derivatives Association, says the bill “would create a narrow test for who could enter into a CDS contract, meaning most people looking to purchase protection against a corporate default would be unable to find a counterparty. The effect of the provision would be to make it extremely difficult for protection buyers to hedge their credit risk.” He adds, “The legislation creates substantial disincentives for the OTC derivatives industry, which in fact has performed fairly well during the recent downturn. Ultimately policymakers may decide that disrupting one of the few remaining functioning sectors of the financial markets does not help the ultimate goal of jump starting the economy.”

In his testimony, National Futures Association President and CEO Daniel J. Roth said, “Eliminating speculators from the credit default swap market will make it much more difficult for firms to manage their risks, which cannot be good for those firms or the economy.”

CME Group, the Intercontinental Exchange and NYSE Euronext all have introduced proposals for central clearing facilities for CDSs. The CFTC and the Federal Reserve Bank of New York granted regulatory approval for clearing CDSs through CMDX, CME Group’s clearing venture, in December, and CME now waits for approval from the Securities and Exchange Commission.

“Congress [should not] dictate how any product should be traded. Even if the regulation makes sense today, tomorrow the product could be in a different form, called something else and fall outside the regulation,” says Gary DeWaal, general counsel for Newedge. “The reason why the off-exchange market exists is it deals with customized products. Futures contracts and clearing only work for standardized contracts. So it’s very difficult to make something that’s customized standardized so that it can actually be cleared.”

Former CFTC Chairman Philip McBride Johnson thinks a bill of some kind will pass but the current bill needs further examination. “On the subject of banning naked CDS, the title to the provision speaks only about the ‘purchasers’ of the CDS having to already possess the underlying financial risk, while the actual text speaks of anyone who ‘enters into’ the CDS, including the seller. Insurance doesn’t work that way. The sellers don’t acquire any interest in my house or car or health before insuring me. This would need to be fixed,” he says.

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