Opinion

Felix Salmon

Prosecuting insider trading in CDS

By Felix Salmon
March 31, 2010

It’s now been three and a half years since Bloomberg’s Shannon Harrington and John Glover showed that there was a very strong pattern of CDS spreads gapping out in advance of debt issuance by large corporates, which came as a surprise to everybody else. And it’s been three years since I noted that the SEC was going to have a hard time prosecuting insider trading in the CDS market, since CDSs aren’t securities.

Since then, of course, we’ve had a major financial crisis and the introduction of financial regulatory reform which would give oversight of single-name CDS to the SEC. But if you need an example of how slowly these things move, just look at the front page of today’s WSJ, which is reporting on an insider-trading case based on trades and phone calls which took place in July 2006:

The defendants in the New York case argue, among other things, that swaps aren’t securities, but private contracts between financial players outside the SEC’s jurisdiction. Unlike most stocks, bonds and options, swaps aren’t traded on an exchange.

It’ll be interesting to see how this case plays out, especially given the much harsher attitudes towards Wall Street in general and credit default swaps in particular that you’re likely to find in the average New York jury pool today as opposed to 2006.

But the first obvious thing that needs to be done here is to give the SEC formal jurisdiction over single-name CDS. Note that this is not one of the cases which Harrington and Glover talked about: those involved information which was obtained legitimately by hedge funds, since hedge funds were involved in the loan syndicates concerned. In those cases, the question was whether the funds were allowed to trade on that privileged information in the CDS market.

This case is slightly easier to prosecute, since it seems to involve a salesman at a regulated sell-side investment bank, Deutsche’s Jon-Paul Rorech, illicitly giving inside information to one of his buy-side clients. That’s illegal whether there’s any trade involved or not, I think.

The second thing which ought to be considered is moving CDS trading onto an exchange, where it can be regulated. And it’s almost certain, at this point, that that’s not going to happen. In fact, I asked Craig Donohue, the CEO of CME Group, about this at yesterday’s Reuters Global Exchanges and Trading Summit. He’s very keen on clearing over-the-counter CDS trades, but he said that he’s come to the decision over the past couple of years that he’s not interested in listing CDS on any of his exchanges directly. The big CDS players are his clients, they make lots of money from their OTC trading, and he seems to have no appetite to start competing with them on that front, rather than simply facilitating the clearing of their trades.

I am hopeful that if and when financial regulatory reform goes through, it’ll give the SEC a bit more in the way of teeth to prosecute rampant insider trading in the CDS market than it has at the moment. Whether we’ll actually see more prosecutions, however, is a very open question, and so long as CDS trading takes place entirely in the shadowy OTC universe, my guess is that the answer will be no.

Comments
4 comments so far | RSS Comments RSS

Regulating CDS won’t really help, you know. The financial industry will just make up some other product so they can say “Oh, this isn’t a CDS, it’s a PDQ and there aren’t any regulations on those.”

Posted by KenInIL | Report as abusive
 

“This case is slightly easier to prosecute, since it seems to involve a salesman at a regulated sell-side investment bank, Deutsche’s Jon-Paul Rorech, illicitly giving inside information to one of his buy-side clients. That’s illegal whether there’s any trade involved or not, I think.”

You can give inside info to a buy-side client, but if you do, you have to “bring them over the wall”, ie make them a privileged insider. If you do, they can’t trade on the information. This has come up recently in the bond markets – which traditionally haven’t seen much insider trading enforcement – as a result of extensive presounding of deals by lead managers. There was a case relatively a while back in the UK where a couple of bond investor/traders were punished (fairly mildly) by the FSA for trading after being pre-sounded by banks on a new bond issue.

Posted by GingerYellow | Report as abusive
 

Um … if we’re going to stamp out insider trading in the CDS market, can we do the same thing in the cash bond market too? Please? And given that the SEC already has authority over bonds, extending this to CDS is what the mathematicians call necessary but not sufficient. Wholesale spine transplants would also seem required.

That’s the weird thing about the exchange-traded CDS idea – the derivative would be more transparent than the underlying. (On what planet do “most” bonds trade on an exchange?)

Posted by Greycap | Report as abusive
 

CDS is nothing short of a gambling vehicle

Posted by Story_Burn | Report as abusive
 

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