New York governor announces CDS regulation

The governor of New York, David Paterson, has declared parts of the credit default swaps (CDS) market will be regulated from January 2009, in an attempt to clamp down on what he described as a major contributor to the emerging crisis on Wall Street.

As part of the plan, revealed yesterday, the New York Insurance Department issued new guidelines that class certain credit default swaps as insurance and therefore subject to state regulation.

The new guidelines state that a buyer of CDS protection is purchasing an insurance contract if that entity owns the underlying bonds. As such, the CDS would be subject to regulation and can only be issued by firms licensed to conduct insurance business.

In all other cases, CDSs would not fall under the oversight of the New York insurance regulator. However, Paterson called on the federal government to regulate the rest of the market, estimated at $62 trillion in outstanding notional as of the end of 2007, according to the International Swaps and Derivatives Association.

In explaining his rationale for introducing the new rules, Paterson said credit default swaps are “a means of profiting from falling values of bonds”, and that the instrument “is similar to a short sale of a stock”.

“The absence of regulatory oversight is the principle cause of the Wall Street meltdown we are currently witnessing,” said Paterson. “I urge the federal government to follow New York’s lead once again by regulating the rest of the credit default swap market, which will have a positive impact on our collective efforts to get the national economy back on track.”

Initial reaction from dealers was that Paterson’s comments demonstrate a lack of understanding of how the CDS market works. In a briefing note written by Tim Backshall, chief strategist at Credit Derivatives Research, a San Francisco-based trading strategy firm, the rules were criticised as ill conceived.

“It is clear from certain sentences within the circular that the parties do not understand the CDS market, what triggers default and why net-net CDSs are a zero-sum game in the absence of counterparty risk,” wrote Backshall. “Furthermore, it is clear the implications (such as greater cost of funding for corporates and increasingly pro-cyclical disconnects between financial firms and non-financial firms) have not been considered.”