economics

March 15, 2010

Wall Street Mobilizes to Shape Look of CDS Rules

Filed under: Uncategorized — ktetaichinh @ 11:57 pm
Tags: ,

Investors expressed frustration and anger Wednesday after reports that U.S. and European governments were eager to place new curbs on the use of credit-default swaps. But some on Wall Street acknowledged that changes to the arcane trading area are inevitable, with some suggesting remedies that might increase transparency while forestalling greater government intervention.

Wednesday, European officials appeared to soften some of their previous statements calling for rules on the swaps, including a possible ban on using them for “speculative” trading. Greece’s prime minister said that he wasn’t trying to “scapegoat” traders for the country’s current budget crisis.

The remarks came after comments Tuesday by the head of the Commodity Futures Trading Commission, who suggested stronger swap rules were essential to broader financial change in America.

Credit-default swaps function like insurance for the default of a bond. If a borrower defaults, the CDS holder is paid by the seller of the protection. But traders don’t need to own the bonds to buy the protection; instead, they can use CDSs to make “naked” bets on the bonds’ direction.

[CDS]

Defenders say CDS buyers often are the smart money who can sniff out problems of, say, a country or company and bet on its decline. They shouldn’t be flogged for good investing sense, they say.

“It’s like blaming a thermometer for the temperature outside,” says Brian Yelvington, director of fixed-income research at Knight Libertas LLC, a Greenwich, Conn., trading firm.

Christopher Iggo, fixed-income chief investment officer at the investment unit of French insurer AXA SA, says he views rising levels of CDS trading as “a gauge of sentiment.” But he says that high CDS volume can offer an indication that the negative sentiment is overdone and that there may be an opportunity to invest, rather than as a sign to pile on against an issuer.

Yet political consensus for the need to improve oversight of the CDS industry is growing, as the lack of regulation is viewed as having exacerbated declines in stock or bond prices of companies and countries alike.

Defenders of CDSs also note that, while there is some $25 trillion in notional CDS exposure outstanding, most of those bets cancel each other out, and the amount of money actually at risk amounts to about $2.5 trillion in total, according to data compiled by the Depository Trust & Clearing Corp. There is roughly $80 trillion in debt outstanding around the world.

Also, defenders say, it might be difficult for regulators to identify which CDS uses are purely speculative. For example, a “naked” CDS trade, in which investors buy CDS protection on a borrower without owning that borrower’s debt, often is used by large investors as indirect hedges of other risks. Banning such trades outright could lead investors to buy fewer bonds or stocks or lend less—an outcome policy makers might later regret.

In a speech Tuesday, CFTC chairman Gary Gensler noted that some observers have said 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.”

The near collapse of insurer American International Group Inc., which made a series of bad CDS bets, also remains fresh in the memories of many regulators. Some of these people say that, while outright bans on the trading would be inappropriate, other measures could improve the market.

H. Rodgin Cohen, chairman of law firm Sullivan & Cromwell and one of the nation’s pre-eminent banking lawyers, said government legislation isn’t the solution to curbing the abuse of derivatives on Wall Street. In a recent speech, he called for improved transparency of the use of derivatives, especially in cases when firms use them solely to make directional bets on the health of a country or company.

[MBLOG]H. Rodgin Cohen

“To me, trying to restrict usage by artificial means is never productive,” he said in an interview, referring to calls to curb the use of derivatives through legislation. “The better way is to have transparency, but also to assess the risk for regulatory capital purposes. The more risk you have, the more capital banks should be required to put up. The largest problem is that capital levels are not sufficiently aligned with risk.”

Many investors are on board with the idea—also advocated by Mr. Gensler—of having standard CDSs cleared and traded on a regulated platform such as an exchange.

“There needs to be an exchange-settlement mechanism in place; as it stands now the counterparty risk is too high,” said Michael Kastner, head of fixed income at Sterling Stamos Capital Management.

Sterling Stamos traded billions of dollars in CDSs in 2008, but got out of the market after the Lehman Brothers collapse. Mr. Kastner suggested the firm might return if clearing and exchange issues were settled. “Even with its flawed nature, it’s a useful market,” he said.

Citigroup Inc. credit-strategist Michael Hampden-Turner, a CDS-market defender, says one alternative to banning some uses of CDSs would be to curb the size of trades hedge funds or others could take by limiting the amount of leverage an investor could use. Currently, a hedge fund or other investor need only put up a relatively small amount of capital—often less than 10%—when buying CDS protection.

A higher amount, he said, “would still enable funds to take positions but [would] reduce the leverage with which they could do it.”

—Sarah N. Lynch contributed to this article.

Leave a Comment »

No comments yet.

RSS feed for comments on this post. TrackBack URI

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Blog at WordPress.com.

%d bloggers like this: