Treasury Today Country Profiles in association with Citi

Small comfort found in CDS regulation

Man handcuffed with the ace of hearts up his sleeve

Increasingly relied upon as an indicator of counterparty risk – whether bank or sovereign – credit default swaps have been in the media once again for all the wrong reasons. Financial engineers are creating far-fetched indices on which to base CDS prices on. What regulation can we expect to boost the credibility of these instruments?

Manipulation of benchmarks has been a consistent theme over the last few months. Following the LIBOR scandal (s), Markit iTraxx, the standard European and Asian tradable credit default swap (CDS) family of indices, has now created a new index that includes three CDS contracts that don’t actually exist.

CDS issuance has been in steep decline so far this year – perhaps as a consequence of the bad reputation they have cultivated in the press recently. And/or due to traders taking a more tentative approach as they wait to assess the impact of a number of regulations that are due to come into force. Either way, according to the Depository Trust & Clearing Corporation (DTCC), trading in individual corporate CDS has fallen 23% by volume this year, on a global basis.

Mr. Regulator?

So this behaviour begs the question as to what exactly is happening on the regulatory front. Last Friday (October 12th) the Dodd-Frank reform on derivatives officially came into force. Trading firms and banks will now need to determine if they are swap execution facilities (SEFs) and if they fall under the remit of the reform’s strict capital and collateral standards. Furthermore, the ban on ‘naked’ CDS (CDS trading which involves the purchase of default insurance contracts without ownership of the related bonds) is due to come into force next month.

Employed to deter the purchase of sovereign CDS for speculation rather than as a tool for reducing risk exposure, this impending ban has received mixed reviews: some cite this trading behaviour as irresponsible and a contributor to the European debt crisis, while others bemoan that the spreads are relied upon as an indicator for potential default.

Yet, Warren Edwardes, CEO of Delphi Risk Management is sceptical about the power of regulation for all credit derivatives, which he has been concerned about for some time. “Credit derivative outcomes are simply too easy to manipulate – more so than interest rate or currency derivatives, even after allowing for LIBOR manipulation. For contracts of any kind where another party has the power to influence the outcome, it is wise to be wary,” he insists, “Caveat Emptor.”

Indeed, recent reports seem to indicate that the current regulation boundaries are not as rigid as they may have originally appeared. In addition to the ‘ban’ providing an exemption for market-makers, if an end-user can show correlation of greater than zero, then they are free to purchase sovereign CDS. However, investors are nonetheless looking for full clarity on the rules before they feel comfortable trading again. And the regulators have not finished yet.

To be continued…

The French regulator Autorité des marchés financiers (AMF), the International Organisation of Securities Commissions (IOSCO) and the US Securities and Exchange Commission (SEC) have all voiced concerns about credit derivatives over the past year. Publishing its own research in March, the SEC demonstrated that 87.2% of CDS transactions are concentrated among the top 15 dealers. And a month after the release of IOSCO’s ‘The Credit Default Swap Market’ report in June, the AMF defined its ‘Further questions about the functioning of the CDS market’ in its Risk and Trend Mapping report.

At an IOSCO board meeting earlier this month (3rd and 4th October), an agreement was also reached on the industry body’s next steps following the issuance of its June report. AMF director, Edouard Vieillefond told Compliance Complete that the CDS market should expect “specific treatment and additional regulatory requirements” by the first half of 2013 at the latest.