The case, filed in the New York Southern District Court, alleged that Renato Negrin, a former portfolio manager at New York-based hedge fund investment adviser Millennium Partners, and Jon-Paul Rorech, a bond and CDS salesman at Deutsche Bank Securities (DBSI) - the investment banking and securities arm of Deutsche Bank in the US -shared confidential information regarding the issuance of new bonds by Dutch media conglomerate VNU in July 2006 and the prices of CDSs referencing those bonds.
According to the SEC, Rorech, "by virtue of his employment at DBSI", became privy to confidential information concerning the restructuring of an upcoming bond issuance by VNU (of which the German bank was the lead underwriter), which he relayed to Negrin.
The bank expected that new issuance would push up the cost of protection on VNU bonds, because the supply of bonds covered by those CDSs was limited. An increase in issuance would result in an increase in exposure and therefore an increase in demand for CDSs covering the bonds, leading to a rise in CDS prices. Rorech, the SEC said, was aware of this, and passed confidential information about the bond issue to Negrin in phone conversations between July 14 and 17, 2006.
Subsequently, on behalf of a hedge fund advised by Millennium Partners, Negrin placed an order with DBSI on July 17 for €1O million worth of VNU CDSs at 383 basis points, and repeated the trade the following day with a different fund. When news of the restructured bond offering became public on July 24, the price of protection on VNU increased substantially, and Negrin closed Millennium Partners' VNU CDS position at a profit of approximately $1.2 million.
With credit derivatives coming under increasing regulatory scrutiny and facing criticism from many quarters for their involvement in the current financial crisis, the SEC's investigation is yet more bad news and could intensify pressure from regulators and market participants to increase transparency in this market. This has been evident in recent initiatives to standardise CDS contracts and to migrate CDS trades onto exchanges for central clearing.
Vivek Tawadey, London-based head of credit portfolio strategy and credit research at BNP Paribas, predicted the VNU case will give even more credence for CDS regulation. "It is hard to say whether a single specific situation reflects a wider trend in the market, but, I would imagine, given all the losses it is only natural to expect greater oversight that will include a focus on fraudulent activity like this going forward," he said.
However, he concluded that the SEC's revelations of insider trading in the CDS space will add little extra impetus to the push for greater transparency. "I don't think insider trading will be a big factor in pushing credit derivatives towards clearing houses; the motive there would be to lower counterparty risk," he noted.
If the bulk of CDSs were traded on exchanges, the likelihood of market abuses similar to the VNU case would be dramatically cut, said Soren Willemann, vice-president of credit derivatives research at Barclays Capital in London. "An investor intending to make money in this way will have a harder time doing so if the majority of clearing is done on exchanges, where user activity can be monitored more closely," he explained.
While this might be the first instance of a civil action involving CDSs, the credit derivatives market is no stranger to this kind of fraud, says a senior credit analyst at a UK bank. "This is not one-off. Insider trading exists in every market," he stated.