SEC calls for CDS regulation

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Calls for greater oversight of the credit default swaps (CDS) market have intensified, following the collapse of Lehman Brothers and the bailout of American International Group.

In testimony to the US Senate Banking Committee on September 23, Christopher Cox, chairman of the US Securities and Exchange Commission (SEC), said there were opportunities for manipulation within CDS markets, which he described as "completely lacking in transparency and completely unregulated".

As the buyer of a CDS could potentially profit on the default of the underlying bond without having to own it, Cox also likened CDSs to naked short selling. "This potential for unfettered naked shorting and the lack of regulation in this market are cause for great concern. I urge you to provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets," he said.

His remarks follow a statement on September 22 by the governor of New York, David Paterson, who declared parts of the CDS market will be regulated from January 2009 to clamp down on what he feels is a major contributor to the crisis on Wall Street.

As part of the plan, the New York Insurance Department issued new guidelines that class certain CDSs as insurance and therefore subject to state regulation. The guidelines state 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. But Paterson called on the federal government to regulate the rest of the market, estimated at $54.6 trillion in outstanding notional at the end of June 2008.

Paterson said CDSs are "a means of profiting from falling values of bonds", and that the instrument "is similar to a short sale of a stock".

He added: "The absence of regulatory oversight is the principal cause of the Wall Street meltdown. I urge federal government to follow New York's lead by regulating the rest of the CDS market, which will have a positive impact on our collective efforts to get the national economy back on track."

Calls for federal supervision of the CDS market have ben opposed by industry representatives. "During the current market volatility, the credit derivatives market has performed very well. Credit derivatives market participants are the first to encourage the SEC to use its authority to ensure attempted manipulation of these markets is punished. However, proposals that would seek to treat privately negotiated contracts as securities, or otherwise apply ill-fitting regulatory regimes to these agreements, are likely to deter healthy economic activity and push derivatives into markets where the SEC has no jurisdiction," said Bob Pickel, New York-based executive director and chief executive of the International Swaps and Derivatives Association.

 

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