Financial Regulatory Forum

Efforts to ban “naked” CDSs could face limits

By Reuters Staff
July 28, 2009

Swiss Re was hit hard by losses in credit default swapsBy Karen Brettell
NEW YORK, July 28 (Reuters) – Efforts to limit speculation with credit default swaps may be ineffective as the large dealers that account for the vast majority of volumes in the market are likely to be exempt from any ban.

U.S. House of Representatives Democrats said in a draft reform bill that lawmakers will consider prohibiting the speculative use of CDSs, with certain exceptions, or require that market participants report all speculative positions to a regulator, who would have the option to limit or ban use of the contracts.

The proposals are part of efforts to shine more light on the opaque, privately traded derivatives markets and reduce systemic risks associated with contracts including CDSs.

Companies including American International Group used CDSs to take outsized exposures to risky debt, which led to a government bailout for AIG.
However, “the exceptions cited under the mandatory exchange/clearing rule and speculation rule tell me the market itself will largely continue on as it has in the past,” said Kevin McPartland, senior analyst at New York-based research and consulting firm TABB Group.

“Mandatory clearing and banned naked CDS make good headlines, but the details show neither will really be the case,” he said.

CDSs are deemed “naked” when a buyer of protection does not also own the debt underlying the contract.

Proposed reforms also include moving “standardized” derivatives to central clearing and exchange trading, and imposing new reporting and higher capital requirements for all trades.

Analysts and market participants have criticized calls to limit speculation in CDSs, arguing that the move would dry up liquidity, in turn making it harder and more expensive for bondholders to hedge their positions.

“The other side of a hedge position is speculators, and so if you remove the ‘speculative’ aspect of it then hedgers might be out of luck,” said John Jay, senior analyst at Boston-based Aite Group.

Congress is considering exceptions to any ban including if a party is “a bona fide market maker,” or “has a qualified economic interest that is protected by the contract,” according to a document obtained by Reuters on Monday.

This may excuse the majority of the market. Dealers account for almost $24 trillion of the $26.6 trillion in gross CDS volumes, according to data by the Depository Trust & Clearing Corp.

“There is a necessity to mitigate the systemic risk inherent in a bilateral world of CDS contracts and therefore move them into a centrally cleared environment,” said Jamie Cawley, chief executive at interdealer CDS broker IDX Capital in New York.

However, “I fail to see how the banning of naked contracts is going to help the systemic risk issue,” he said.

Regulators have cited concerns that speculators used CDSs to take short positions in banks, and that price moves in the contracts pushed down their stock prices, exacerbating concerns over their financial health.

Reporting requirements and regulation, however, would give insight to any market manipulation, without the negative effects of a ban, analysts said.

“It probably is a fair statement to say that there probably was this type of tactic employed, but it’s one of those types of instances where I wonder if the exception might be applied in a blanket manner inappropriately,” said Aite Group’s Jay.

“Just because you short the stock it doesn’t necessarily have to go in your favor so anybody employing such a strategy is not ensured of profitability,” he said. (Editing by James Dalgleish)

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