House: rules for credit default swap

Fed up with the inability or unwillingness of financial wizards and Wall Street players to speak anything but economic gobbledygook, Sen. Tom Harkin, chairman of the Senate Agriculture Committee, recently said he’d pay cash money to anyone able to explain credit swaps and derivatives in layman’s English. If anyone has taken him up on the offer, it has gone unreported.

But one thing is for sure: in testimony before Congress, the market “gurus” haven’t quit with the verbal gymnastics and obfuscation. And the confusion over how the globe ended up in a financial crisis — and how it might be best solved — continues.

Credit default swaps

A quick aside: the Wikipedia entry for a credit default swap 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 on the occurrence of a specified credit event (for example bankruptcy or restructuring). Credit default swaps can be bought by any (relatively sophisticated) investor; it is not necessary for the buyer to own the underlying credit instrument.

“As an example, imagine that an investor buys a CDS from ABC Bank, where the reference entity is XYZ Corp. The investor will make regular payments to ABC Bank, and if XYZ Corp defaults on its debt (i.e., it does not repay it), the investor will receive a one-off payment from ABC Bank and the CDS contract is terminated.”

Incredibly, thanks to Congress, the insurance scheme explained above was allowed to go unregulated. Estimates put the current worth of CDS at some $60 trillion.

On Oct. 15, the House Agriculture Committee — under the auspices of the Commodities Exchange Act — met to review the role of credit derivatives in the U.S. economy.

“I’m interested in getting a clearing situation set up for the credit default swaps,” said Minnesota Rep. Collin Peterson, who chairs the committee. “As I understand it, there are discussions going on between the different parties — the Securities Exchange Commission, the Commodity Futures Trading Commission, the Fed, different groups — that are working on this.”

As competing solutions to the situation are floated, the various factions involved — both business and governmental — are staking out territory, warned Peterson. The House Agriculture Committee, he promised several times, would cede no regulatory ground.

To bring some stability to the markets and once again open screwed-tight credit spigots, the CDS “need to be cleared” by a process yet to be determined.

Much of the distrust in the markets and lack of credit available is due to the now infamous CDS, insisted Peterson. “The sooner we can get these clearing mechanisms set up, the better we’ll be.

“Everyone is afraid to borrow because there might be something out there they don’t know about. Within three days, your money could be gone.

“This is a big problem and we have a big responsibility to get it right. This committee is more of an impartial panel, if you will, because we aren’t as close to Wall Street or other folks that got us into this mess. We can take a more open-minded view of solutions than some other folks around this town.”

Rep. Bob Etheridge’s North Carolina constituents have been asking, “‘How did we get into this financial mess?’ They’ve heard some of my colleagues from the Republican side theorizing that blame lies with the Democrats. Democrats have theorized (the blame lies) with Republicans. The truth is there’s a lot of blame to go around and a lot of people share responsibility for this mess.”

The regulatory regime in operation today “is a construct developed years ago with bipartisan support, through bipartisan legislation. Today, we’re looking at over-the-counter credit derivatives — particularly credit default swaps, which constitute the vast majority of these derivatives.”

Currently, there is no specific regulation for these financial instruments. This fact, said Etheridge, “isn’t by accident, but by design.”

In fact, the congressional agriculture committees could have been policing the CDS. “This committee has jurisdiction over the Commodities Exchange Act. In 2000, Congress passed legislation in the Commodities Futures Modernization Act that expressly stated the CEA wouldn’t apply to these derivatives.”

Etheridge said he was told by the “financial community and others that we needed to modernize our regulatory structure to compete with financial institutions in Europe and elsewhere. We were assured the parties to these financial instruments were responsible and sophisticated enough to engage in these transactions without need for heavy government and regulatory oversight.”

Then, “like trusting parents, we let the big boys and girls go out to the financial playground thinking we didn’t need to watch over them to keep them from (being) hurt. Little did we know, (that instead) they’d end up trashing the playground. We never guessed the major players would grow up to be so big that the collapse of one would bring down the financial system.”


Walter Lukken, the acting chairman of the CFTC, agreed with Peterson that clearing the swaps “cooperatively and expeditiously” is essential in the short-term. Further, “while the implementation of centralized clearing … is a near-term solution that doesn’t require legislative changes, broader reform of the derivatives market is also needed and will require decisive congressional action.”

As Congress works on reform, Lukken offered several guiding objectives to prevent a similar economic disturbance in the future:

• “First, and foremost, regulatory reform should seek to improve the transparency of these (over-the-counter, which the CDS are a part of) markets, particularly when their size reaches the critical mass when they play a public pricing role and their failure might cause a systemic event. … Enhanced transparency through reporting or other means would enable regulators to properly police these markets for misconduct and concentration of risk.”

Congress, while pursuing this objective, might look to the model adopted in the farm bill “for the OTC energy swaps market, which trigger additional oversight and transparency when a product begins to serve a significant price discovery function.”

• Second, “regulatory reform should incentivize — and possibly even mandate — the centralized clearing and settlement for certain OTC derivatives.”

• Third, “regulatory reform should revisit the amount of risk-based capital held by dealer firms and large participants in the OTC markets to better account for the interdependent counterparty risk that now seems so evident and to prevent these products from being held off balance sheets and unregulated affiliates. As clearing begins for these products and trading data improves, models for assessing risk will also progress as will the accuracy of the capital charges assigned to these firms.”

• Fourth, “regulatory reform should provide for clear enforcement authority over these products to police against fraud and manipulation. The CFTC is currently excluded by statute from bringing enforcement cases against OTC financial derivatives. Congress should rectify this by providing clear enforcement powers regarding OTC products to the CFTC and other appropriate regulators such as the SEC.”

• Fifth, “regulatory reform of OTC products should be globally coordinated and non-exclusionary. As this crisis has shown, the world financial system is highly intertwined leaving no country’s banking system unscathed. We’ve also learned that one country’s action to stem the crisis can’t be effective without close cooperation among all nations.”

Lukken warned that when the focus shifts to long-term solutions and adjustments to the global regulatory structure, “world legislators must work in close concert to ensure that steps taken by one nation to improve oversight aren’t exploited by others in the global financial community. This also means that domestic regulators should work in tandem and not engage in the unproductive exercise of defending jurisdictional lines at a time when a comprehensive and coordinated response by regulators is most needed.”

Over the last several years, the CDS market has grown incredibly. “As of the end of the first half of 2008, the total notional value of CDS is estimated to be approximately $55 trillion, doubling its size in only two years,” said Erik Sirri, the director of the SEC’s Division of Trading and Markets.

Sirri said the SEC has watched CDS spreads “move in tandem with falling stock prices, a correlation that suggests that activities in the OTC CDS market may in fact be spilling over into the cash securities markets.”

As for regulating the situation, the SEC is in a jam as it “is limited to enforcing antifraud prohibitions under the federal securities laws, including prohibitions against insider trading. I note, however, that if CDS were standardized as a result of centralized clearing or exchange trading or other changes in the market and (were) no longer individually negotiated, the swap exclusion for the securities laws under the Commodity Futures Modernization Act would be unavailable. Under current law, the SEC is statutorily prohibited from promulgating any rules regarding CDS trading in the over-the-counter market. Thus, the tools necessary to oversee (this) market effectively and efficiently do not exist.”


Returning to his theme of impatience with a burgeoning turf war between potential market regulators, Peterson said, “It seems to me the industry is (trying to) figure out who can get control of this. Some are trying to figure out how to keep the current system going without regulation. For those trying to do that, I don’t know what planet they’re living on.”

Peterson wanted to know if more than one CDS clearinghouse is a good idea.

The Intercontinental Exchange, he pointed out, “wants to be regulated by the Fed. As I understand it, the Fed has never done this. What sense does that make? The SEC and CFTC do (such clearing and regulation). I don’t know what this is all about, if they want to get away from this committee to one that has more people friendly to them, or what they’re up to. But they’ll have a hell of a fight with us if that’s what they’re up to.”

More than one of the clearinghouse entities can work, said Lukken. “I think there are efficiencies having one central counter party. But the law allows for multiple central counter parties to compete for this business. …When you have more than one, what’s key for regulators is close information sharing and cooperation.”

(To read opening statements of those testifying before the committee, go to

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