Regulation of Credit Default Swaps
Regulating derivatives dealers and requiring transparent trading and central clearing of standardized derivatives would greatly reduce risk in the credit default swap market. Additional reforms, however, should be considered to address the unique characteristics of the products. The CFTC is very fortunate to have a strong working relationship with the Securities and Exchange Commission (SEC). Under the Administration’s regulatory reform proposal, both agencies have a role to play, consistent with longstanding precedent, in regulating the CDS markets. The SEC would take the lead on single-issuer and narrow-based CDS, and the CFTC would take the lead on broad-based products. While the views expressed in this speech are my own, we are closely consulting with the SEC on appropriate regulatory reform of credit default swaps and the broader over-the-counter marketplace.
The CFTC and the SEC should have clear authority to police the over-the-counter derivatives markets for fraud, manipulation and other abuses. It is important that these markets serve to help people hedge risk as well as provide for efficient and transparent price discovery markets.
At the height of the crisis in the fall of 2008, stock prices, particularly of financial companies, were in a free fall. Some observers believe that CDS figured into that decline. They contend that, as buyers of credit default swaps had an incentive to see a company fail, they may have engaged in market activity to help undermine an underlying company’s prospects. This analysis has led some observers to suggest that credit default swap trading should be restricted or even prohibited when the protection buyer does not have an underlying interest.
Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that “a mischievous kind of gaming or wagering” had caused “great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.” The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be “null and void to all intents and purposes.”
For a time, however, it remained legal to buy insurance on another person’s life in England. It took another 28 years and a new king, King George III, before Parliament banned insuring a life without an insurable interest.
The debate over the role of speculators in markets did not end in the 18th century. That debate continued as the CFTC’s predecessor and the SEC were set up following an earlier crisis and that debate continues on to this day. In the case of futures, Congress determined that speculators should be able to meet hedgers in a centralized marketplace. In the oil market, for example, a speculator that will neither produce nor purchase oil is able to buy or sell oil futures. But Congress did require that all such futures trading be regulated, that markets be protected against fraud and manipulation
and that regulators be authorized to limit the size of the position that a speculator can take.
The Administration has recommended – and the House financial regulatory reform bill that passed in December includes – critical steps to address the use of CDS to manipulate markets or possibly commit other abuses. With regard to single-issuer CDS or narrow-based CDS, the SEC should have consistent authority over all financial instruments subject to its jurisdiction. The SEC should have the same general anti-fraud and anti-manipulation rulemaking authority with respect to credit default swaps under its jurisdiction as it has with regard to all securities and securities derivatives under its jurisdiction. In addition, the SEC should have authority to set position limits in single-issuer and narrow-based CDS markets as it now has for other single-issuer or narrow-based securities derivatives. The House bill allows the SEC to aggregate and limit positions with respect to an underlying entity across markets, including options, equity securities, debt and single-stock futures markets.
Credit default swaps also can play a significant role once a company has defaulted or gone into bankruptcy. Bondholders and creditors who have CDS protection that exceeds their actual credit exposure may thus benefit more from the underlying company’s bankruptcy than if the underlying company succeeds. These parties, sometimes called “empty creditors,” might have an incentive to force a company into default or bankruptcy. These so-called empty creditors also have different economic interests once a company defaults than other creditors who are not CDS holders.
These incentives result from the separation of economic risk from beneficial ownership. In the capital markets, assuming economic risk usually comes with some type of governance right. Shareholders place their investment at risk, which brings the right to vote and to inspect books and records. Debtholders may extend credit or buy bonds along with rights as outlined in various debt covenants and indentures, as well as having rights in bankruptcy court.
Though reform efforts to date have yet to address the bankruptcy laws, we should seriously consider modifications to address this new development in capital markets. One possible reform would be to require CDS-protected creditors of bankrupt companies to disclose their positions. Another is to specifically authorize bankruptcy judges to restrict or limit the participation of “empty creditors” in bankruptcy proceedings.
Adequate Capital and Risk Management
Credit default swaps also play a significant role in how banks manage their regulatory capital requirements. Under the Basel II capital accords, large banks and investment banks could significantly decrease their regulatory capital by relying on “credit risk mitigants,” including CDS positions on existing exposures. U.S. standards under the Advanced Capital Adequacy Framework, though more conservative on this matter than Basel II implementation elsewhere, also allows for some reduction of regulatory capital when a bank purchased CDS protection from an eligible entity. So, a bank can essentially rent another institution’s credit rating to reduce its required capital.
Two lessons emerge from the role of CDS in this context. First, bank capital regulation should be modified to make the use of CDS for capital reduction more restrictive. For example, possibly only CDS subject to collateral requirements could be allowed to provide capital relief, or a bank’s exposure to particular CDS protection sellers could be limited. These measures are within the current regulatory authority of bank regulators, and I am hopeful that internationally coordinated and consistent revisions to the capital adequacy regime that are currently underway will consider such suggestions.
Second, as credit default swaps played such a central role across the financial industry failure of 2008, I believe to the extent Congress were to have any end-user exemption from trading or clearing, there should be no such exemption for CDS products. Fully 95 percent of this market is between financial institutions.
Lastly, credit default swaps also played a significant role in how mortgage and other asset securitizations were done leading up to the crisis. Though CDS at first was promoted as an important market innovation, their development ultimately contributed to lower underwriting standards. Investment banks and other packagers of mortgages wrapping securities with credit protection for sale to investors could reduce their efforts in analyzing the risk that due diligence would otherwise require. The crisis certainly shows the disastrous effects of investors and underwriters relying far too heavily on this protection. It is important that reform enable the CFTC and SEC to write rules to establish recordkeeping and reporting rules as well as business conduct standards to help address these risks.
We need broad regulatory reform of over-the-counter derivatives to best lower risk and promote transparency in the marketplace. While similar to other derivatives, credit default swaps have unique features that require additional consideration. Only with comprehensive reform can we be sure to fully protect the American public.