The role that credit default swaps (CDS) have played in the recent turmoil in financial markets, including the downfall of AIG, has focused the attention of state, federal and international regulators and legislators on these financial instruments. Until now, CDS have been largely unregulated. That is about to change.
The last several months have seen a number of actions aimed at regulating the CDS market. On September 22, the New York Department of Insurance announced that it will regulate covered CDS agreements as insurance contracts. In addition, the New York Attorney General’s office has launched an investigation to determine whether short sellers may have manipulated CDS transactions to push down the price of stocks. Other states also are considering regulating CDS as insurance, and the National Association of Insurance Commissioners (NAIC) has formed a working group to examine coordinated state regulation in this area. The NAIC also recently released proposed changes to statutory accounting standards that will require insurers to provide greater disclosure regarding their holdings of credit derivatives and credit-based guarantees.
Regulatory attention on the CDS market is not limited to the states. In September, Securities and Exchange Commission (SEC) Chairman Christopher Cox requested that Congress grant the SEC jurisdiction to regulate the CDS market. The Federal Reserve and the Commodity Futures Trading Commission (CFTC) also are looking at ways to regulate CDS transactions. On November 14, the SEC, CFTC and Federal Reserve released a memorandum of understanding pledging cooperation in overseeing clearing platforms being developed in the private sector for CDS and other derivatives. Some of these clearing platforms may become operational even before this article goes to press.
An Overview of CDS
A CDS is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default or some other specified credit event occurs (such as bankruptcy or a restructuring). It is not necessary for the buyer of a CDS to own the underlying credit instrument.
As an example, imagine that an investor buys a CDS from Bank, where the reference credit is a debt obligation of B.I.G. Corporation. The investor will make regular payments to Bank under the CDS, and if the reference debt of B.I.G. goes into default (or B.I.G. suffers some other, specified credit event), the investor will receive a lump sum payment from Bank and the CDS contract will terminate. If the investor actually owns the referenced B.I.G. debt, the CDS is referred to as a “covered” swap and can be thought of as hedging. Investors, however, also can buy CDS contracts referencing B.I.G. debt, without actually owning any B.I.G. debt. This is referred to as a “naked” swap and may be done for speculative purposes, betting against the solvency of B.I.G. in a gamble to make money if the company fails, or to offset other risk that may or may not be directly related to B.I.G.’s prospects.
Credit default swaps are entered into using “over-the-counter” or “OTC” trades, meaning that the terms of each swap are privately negotiated between the parties to the swap. The swaps are usually documented on the standard forms of the International Swaps and Derivatives Association (ISDA), but each swap may have its own specific, negotiated terms.
Credit default swaps originated in 1997 and their regulatory status at the federal level was established by the Commodity Futures Modernization Act of 2000 (CFMA). Under the CFMA, CDS were defined as “swap agreements” rather than “securities,” placing them outside the reach of most SEC regulations. They were also generally excluded from being treated as “futures” under the Commodity Exchange Act. While a CDS functions like insurance for the buyer if the buyer suffers an actual loss as a result of the default on the underlying referenced credit, pursuant to the prior position of the New York Insurance Department, CDS were not classified as insurance, in part because no insurable interest (or actual loss or indemnity) was required, and in part because the department relied on such trades being documented on standard forms developed by ISDA and negotiated by the parties as standard swaps.
The growth of the CDS market since 2003 has been remarkable, with the market reaching an estimated currently outstanding notional amount in excess of $60 trillion, more than the gross domestic product of all the nations on earth, combined.
New York’s Decision to Regulate CDS
Recently, in a reversal of its previous view, the New York Department of Insurance (the Department) announced that it would regulate CDS agreements as “insurance contracts” in any instance in which the buyer “at the time the agreement is entered into, holds, or reasonably expects to hold, a ‘material interest’ in the referenced obligation.” CDS agreements that fall within this description and have a sufficient nexus with New York will be required to be written by an insurer licensed as a financial guaranty insurance company under New York law. In addition, such agreements will be subject to certain “Best Practices” guidelines issued by the Department for financial guaranty insurers.
The Department’s revised view that certain CDS agreements constitute insurance comes in the form of a Circular Letter—Circular Letter 19—and an accompanying press release from the Governor’s office, both of which were released on September 22, 2008. Circular Letter 19 is effective January 1, 2009.
Circular Letter 19 leaves open the issue of what constitutes a “material interest” in the referenced obligation under a CDS agreement sufficient to cause the agreement to be deemed an insurance contract. It is clear that the Department does not intend to regulate naked CDS. It is equally clear that the Department will regulate CDS as insurance where the buyer owns legal title to the referenced obligation. It remains to be seen, however, where the Department will draw the line between these two extremes. The Department states in Circular Letter 19 that it intends to issue additional guidance clarifying its position on this issue.
CDS agreements guaranteed by insurers subject to the Department’s jurisdiction will be subject to the Best Practices guidelines set forth in Circular Letter 19. Among other things, the guidelines provide that an insurer guaranteeing CDS will be permitted to offer protection against a pool of asset-backed securities that is comprised of, or includes portions of, other asset-backed securities only if (i) the insurer holds an unsubordinated, senior position with an investment rating of single-A or above, (ii) the pool consists solely of asset-backed securities that are issued or guaranteed by a government-sponsored enterprise or certain similar entities, or (iii) certain other conditions limiting risk are present. In addition, in an attempt to limit the exposure of insurers to accelerated liability, the guidelines restrict the guarantee an insurer may offer on CDS to circumstances where there is a failure to pay an obligation when due and payable as a result of default or insolvency. The guidelines also prohibit insurers from offering guarantees of CDS that require the insurer to post collateral. The Department states in Circular 19 that it will be issuing regulations defining permissible credit and termination events that may trigger payment under CDS backed by an insurer.
Other States Are Considering Whether to Regulate
A number of other states are considering whether to regulate CDS as insurance. The National Association of Insurance Commissioners (NAIC) has organized a Working Group to examine the issues arising from the proliferation of the CDS markets and to consider various approaches to the regulation of CDS under the insurance laws. Additionally, revised statutory accounting rules recently released for comment by the NAIC modify the financial disclosure obligations of insurance companies relative to their CDS holdings and exposure. The proposed amendments would require any insurers which are sellers of credit derivatives to disclose additional information regarding their holdings of credit derivatives and credit-based guarantees to help others evaluate the impact of these products on the company’s financial position, financial performance and cash flow. The comment period for the proposed amendments ended November 10th, public hearings are proposed for the December meeting of the NAIC and the revised rules are proposed to apply to annual statements filed after December 31, 2008. In its recommendation of the changes, the NAIC staff noted that the significant growth of credit default swap products and their potentially adverse effect on the financial condition of insurers required that “thorough credit derivative and guarantee disclosures are necessary to provide state regulators the ability to fully understand the solvency condition of insurers that guarantee, or otherwise provide the credit protection, for credit derivatives and credit-related guarantees.” The statutory accounting sections to be amended by the proposal are SSAP No. 86 – Accounting for Derivative Instruments and Hedging Activities, paragraph 53 and SSAP No. 5 – Liabilities, Contingencies and Impairment of Assets, paragraph 16.
With respect to efforts to regulate CDS as insurance, insurance regulators have focused on covered swaps because of their similarities to financial guaranty insurance. Though covered swaps only comprise approximately 10% of the CDS market, according to the NAIC, most state regulators believe that existing law already provides them the right to regulate these swaps as insurance contracts. A number of insurance regulators have questioned whether naked CDS should be allowed at all. While the NAIC has suggested that the CDS market will not lend itself to an easy separation into products that are insurance contracts and those that are not, they would support a comprehensive solution that provides transparency and includes capital or margin requirements and security funds or other mechanisms to control counterparty risk. According to the NAIC, “In the absence of congressional action to legislate an effective comprehensive approach of regulating this market, insurance regulators intend to do what is necessary, within their authority as financial guaranty insurance regulators, to provide this protection is a manner consistent with solvency regulation of other insurance products.”
Developments in the Federal Regulation of CDS
In an October New York Times Op-Ed piece, Christopher Cox, the Chairman of the SEC, identified the primary objectives that he believed were critical to begin the reform of the CDS market. These are: enhanced transparency in CDS trading, more reliable systems for valuation of CDS, reliable methods for CDS participants to assess counterparty risk, and regulatory authority to identify and address fraudulent or manipulative trading practices in the CDS market. To promote transparency, Cox advocates public reporting of trades and trade values by dealers. This, he suggests, will not only give market participants a clearer picture of the activity in the market, but will also allow participants to assess the value of positions in the market. Reporting would also create consistent transaction records that would permit regulators to more easily identify fraudulent or manipulative trading activity. Next, Cox believes that the SEC should be given clear authority to regulate fraudulent, deceptive or manipulative acts and practices relating to the CDS markets. Finally, he supports current efforts to develop central counterparties and exchange-like trading platforms for the market in order to promote transparency and provide to the investors additional methods for assessing the risks associated with the CDS market.
“The regulatory black hole for credit default swaps is one of the most significant issues we are confronting in the current credit crisis, and it requires immediate legislative action,” Cox said. “Manipulation in this completely unregulated and hidden space can drive prices in the regulated market for securities. That is why I believe it is important for Congress to act now to provide for regulatory oversight of the credit default swaps market.”
Echoing these comments have been calls for increased federal regulation of the CDS market from U.S. legislators, such as Senator Tom Harkins (D-Iowa), the Chairman of the Senate Committee on Agriculture, Nutrition and Forestry (the Senate Committee that oversees the commodities futures markets). Among his comments, Harkins characterized the market as part of “casino capitalism” operating outside any meaningful federal regulation. Harkin has introduced legislation that would ban naked swaps.
On November 14th, the President’s Working Group on Financial Markets (PWG) which consists of Chairman Cox, Walter Lukken (the Acting Chairman of the Commodity Futures Trading Commission), Ben Bernanke (the Chairman of the Board of Governors of the Federal Reserve System), and Henry Paulson (the Secretary of the Department of the Treasury), released their “Policy Objectives for the OTC Derivative Market.” These objectives are: (1) improve market transparency and integrity for CDS, (2) enhance risk management of OTC derivatives, (3) strengthen OTC derivatives market infrastructure, and (4) continue cooperation among regulatory authorities. In the release, the PWG confirmed that their highest near-term objective is the establishment of central counterparty services for CDS, an objective that they believe will reduce systemic risk in the CDS market and provide greater market transparency. They also confirmed that “several potential counterparty providers” are actively developing such services and that regulators are currently evaluating the developing options, with the objective of accelerating the regulatory approval so that one or more CDS central counterparties can be operational before the end of 2008. At the same time, the PWG released the Memorandum of Understanding among Cox, Lukken and Bernanke by which these three major federal regulators confirmed their agreement to cooperate, coordinate and share information in relation to the establishment of the new central counterparties for CDS.
The development of a comprehensive regulatory framework for the CDS market, even with the full cooperation and coordination of the primary U.S. federal regulators, may still be a very difficult task due to the global nature of the market. Since CDS are frequently bought and sold between parties located in major financial centers throughout the world, it seems that any effort to regulate CDS in a meaningful way will require the coordination of regulators from each of those countries, otherwise the CDS market may just migrate to the jurisdiction having the least regulation.
Conclusion
The recent flurry of regulatory action surrounding CDS poses interesting questions, the answers to which have yet to be resolved. Greater regulation of CDS is a certainty, but what form will it take? In broad terms, it seems clear that any new regulation will mandate greater transparency for CDS transactions coupled with solvency and risk mitigation standards for the sellers of credit protection. Beyond that, the details have yet to emerge. It also seems clear that close cooperation will be required among state, federal and international regulators. State regulators have begun to craft regulatory controls for covered swaps, but such transactions represent only a small portion of the CDS market. Moreover, state regulators face the obvious problem that CDS transactions can be structured to place them outside the jurisdiction of a particular state. Given the growing federal commitment to the solvency of protection sellers, it may be that federal regulation of CDS will supersede state action in this area. In addition, federal regulators face a problem similar to that confronted by state authorities in that the CDS market is global. Only internationally coordinated regulation of CDS is likely to be effective.
Note: On November 20, just prior to publication of this article, New York Insurance Superintendent Eric Dinallo announced that New York will delay indefinitely its plans to regulate covered CDS in recognition that federal authorities are working to develop a comprehensive solution for regulating the CDS market, including both covered and naked swaps. “We understand that the market for credit default swaps is large and complex and it will take time to complete a holistic solution. But while we support these beginning [federal] efforts, we also recognize that they do not yet constitute a completely transparent and fully regulated market. We urge the industry, federal agencies and Congress to continue working until that essential goal is reached. At that point, we will be prepared to consider any necessary changes in state law to prevent problems that might arise from the fact that some swaps are insurance,” Dinallo said.
Ward S. Bondurant is a Partner in the firm’s Insurance and Corporate Practice. Mr. Bondurant has counseled businesses in general corporate and corporate finance matters for over 20 years, with his primary focus on representing clients in the insurance industry. Mr. Bondurant received his bachelor’s degree from University of North Carolina and his law degree from University of Georgia.
Joseph T. Holahan is Of Counsel in the firm’s Insurance Practice. He also is a member of the firm’s Privacy Practice. Mr. Holahan advises insurers and reinsurers on a variety of legal matters, including all aspects of regulatory compliance. His experience includes assisting insurers with company formation and licensing, including the formation of alternative risk transfer vehicles; mergers and acquisitions; corporate restructuring; assumption reinsurance; portfolio transfers and other transactions. He also advises clients on the negotiation of reinsurance agreements and development of policy forms. In addition, Mr. Holahan has substantial expertise in the law of information privacy and security. He regularly advises clients engaged in insurance and other financial services on compliance with state and federal requirements in this area.
