US agriculture committee plans to ban naked CDSs

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WASHINGTON DC - The US House of Representatives Committee on Agriculture has published a draft bill seeking to limit the holding of credit default swap (CDS) contracts to market participants owning the bonds of the reference entity in question.

In the draft of the Derivatives Markets Transparency and Accountability Act, the Committee proposes a rule that would make it "unlawful for any person to enter into a credit default swap unless the person would experience financial loss if an event that is the subject of the credit default swap occurs".

The law, which could decimate the CDS market in its current form, was partly inspired by the Federal Reserve's rescue of American International Group after the insurer's financial products division wrote massive volumes of CDS business without appropriately hedging its exposure, nearly bankrupting the firm.

Regulators' attention has also turned to the credit derivatives market after claims that swap positions held by predatory market participants may have encouraged hedge funds and speculators to actively erode counterparty confidence in broker-dealers such as Bear Stearns and Merrill Lynch, in order to profit from their respective collapses. Similar accusations about naked short-selling led the Securities and Exchange Commission to ban naked shorts on 1,000 stocks in the US in September and October last year.

The bill defines a CDS as "a contract which insures a party to the contract against the risk that an entity may experience a loss of value as a result of an event specified in the contract, such as a default or credit downgrade".

The characterisation of CDSs as insurance differs markedly from the International Swaps and Derivatives Association's definition as a "contract in which one party pays a periodic fee to another party in return for compensation for default by a reference entity. It is not necessary for the protection buyer to suffer an actual loss to be eligible for compensation if a credit event occurs."

The Agriculture Committee is involved in the CDS regulation debate through its oversight of the Commodity Futures Trading Commission, the commodities supervisor with regulatory authority over the Chicago Mercantile Exchange and Atlanta-based Intercontinental Exchange, two of the exchanges planning to offer central clearing of CDS contracts.

On December 8, the committee held its second set of hearings on the role of credit derivatives in the US economy, hearing testimony from senior managers from all four prospective CDS clearing houses, financial regulators and industry associations.

Both the Senate Banking Committee and the House Financial Services Committees are expected to hold their own hearings on the role of CDS contracts in the financial crisis in the coming months.