By Judith Burns of DOW JONES NEWSWIRES September 23, 2008
Securities and Exchange Commission Chairman Christopher Cox Tuesday asked Congress for explicit authority to regulate credit-default swaps, plugging a $58 trillion regulatory hole. Skeptics have two words to say about that: "Good luck."
Cox isn't the first regulator to try to grab hold of the rapidly expanding market, which provides protection when borrowers default on bonds or other debt. A decade ago, the Commodity Futures Trading Commission, which oversees futures markets, staked out a claim to regulate credit-default swaps, kicking off a two- year debate about the legal status of such instruments.
Congress resolved the legal question in 2000 with the passage of the Commodity Futures Modernization Act, which barred the CFTC from regulating credit-default swaps.
The law made it "crystal clear" that the CFTC would have no authority over the market, said Michael Greenberger, a professor at University of Maryland Law School and former head of the CFTC's trading and markets division.
The SEC's authority over credit-default swaps is limited. While it has broad antifraud authority to investigate market manipulation, its hands are tied when it comes to regulating credit-default swaps: it can't issue rules, including rules that would require public disclosure about the instruments. "It has put them out of bounds to regulators," said Greenberger. He lamented that, saying, "I think somebody at the federal level needs to have that authority."
One concern is the size of the credit-default swaps market, which has ballooned very rapidly, using non-standard, paper-based contracts that don't trade on exchanges. Cox said the notional market in credit-default swaps stands at $58 trillion, double the amount outstanding in 2006, yet the market "is regulated by no one."
While such contracts have legitimate uses, some fear that the protection they offer could lead market participants to take risks they might not otherwise. Just who is using the instruments and who is backing them aren't clear, however. Also unclear is whether the parties who sell the protection to swaps buyers have the financial strength to make good on their promises, since there are no minimum standards for capital strength or liquidity.
Scant information on credit-default swaps is a worry, prompting efforts by the Federal Reserve Bank of New York to push market participants for better disclosure and creation of a central clearinghouse for credit-default swaps trades.
Opportunities for credit-default swaps to be abused in insider-trading or market-manipulation schemes are an issue as well. Since credit-default swaps may be used by speculators as well as those seeking protection against a credit default, regulators worry they could be a powerful tool for manipulators. The SEC announced last week that it is investigating whether brokers, hedge funds and other money managers might have used credit-default swaps to pressure stock prices lower, producing profits for short sellers.
Some question whether the SEC has jurisdiction to conduct such probes, and a crucial issue may be whether SEC subpoenas target trading in credit-default swaps that are "security-based" or "nonsecurity based," attorneys at the law firm of Schulte, Roth & Zabel wrote in a client alert Monday.
States are jumping into the breach, at least in part. New York State Gov. David Paterson announced Monday that the state will begin regulating a slice of the credit-default swap market, starting Jan. 1. New York stepped in after a federal bailout of American International Group Inc. (AIG), which fumbled because of bad bets on credit-default swaps.
"The most promising route to legislation is through the states," said Greenberger. He said a rush toward state regulation could prompt Congress to pre-empt state action with a new federal law. State regulation of credit- default swaps "might actually make federal regulation look attractive," said Robert Claassen, a partner at the law firm Paul Hastings, in New York, who represents brokerage and hedge-funds clients. Yet Claassen worries that the SEC's hands-on regulatory approach isn't appropriate for the credit-default swap market, where sophisticated counter parties willingly transfer big risks on little more than a handshake. "That would kill it," or force the market offshore to London or Hong Kong, Claassen warned. He prefers alternatives to improve documentation and form a central clearinghouse, which might require standardization of swaps contracts.
Industry groups such as the International Swaps and Derivatives Association raised similar concerns in a statement Tuesday that warned against treating credit-default swaps as securities. Greenberger expects such opposition will prevent Congress from moving this year to regulate credit-default swaps, even though, "now's the time when there's the leverage to do it."
Putting regulation of credit-default swaps on the table a decade ago led to the idea being shot down, Greenberger recalled. In May 1998, the CFTC, then chaired by Brooksley Born, issued a so-called concept release asking what kind of regulation might be appropriate. The release didn't suggest that such swaps be traded on exchanges, but outlined alternatives that would provide authority to combat fraud and manipulation, and set standards for capital adequacy of those backing the swaps.
A backlash to the proposal quickly came from Alan Greenspan, then the Fed chairman, Treasury Secretary Robert Rubin and SEC Chairman Arthur Levitt, and from Congress, and Greenberger said "it was never formally taken up" by the CFTC