Prosecuting insider trading in CDS

By Felix Salmon
March 31, 2010
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.

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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.

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