No. 09-06 March 2009 WORKING PAPER GUILTY BY ASSOCIATION? Regulating Credit Default Swaps By Houman B. Shadab The ideas presented in this research are the author’s and do not represent official positions of the Mercatus Center at George Mason University. Entrepreneurial Business Law Journal, Forthcoming Fall 2009 This draft last revised on 08/19/09. Comments welcome to [email protected]. GUILTY BY ASSOCIATION? REGULATING CREDIT DEFAULT SWAPS HOUMAN B. SHADAB* Abstract In response to a need for greater regulation and oversight of credit default swaps (CDS), recently the Securities and Exchange Commission (SEC), both Houses of Congress, the Treasury Department, and state insurance regulators initiated a series of actions to bring greater regulation and oversight to CDS and other over-the-counter derivatives. The policymakers’ stated motivations echoed widely expressed criticisms of the regulation, characteristics, and practices of the CDS market, and focused on the risks of the instruments and the lack of public transparency over their utilization and execution. Certainly, the misuse of CDS enabled mortgage-backed security risk to be overconcentrated in some financial institutions. Yet as the analysis in this Article suggests, failing to distinguish between CDS derivatives and the actual mortgage-related debt securities, entities, and practices at the root of the financial crisis may hold CDS guilty by association. Although the financial instruments share some superficial similarities, structured debt securities are very different from CDS and underwriters of such securities make financial decisions under a very different legal and economic framework than those made by CDS dealers. Unmanageable losses from CDS exposures were largely symptomatic of underlying deficiencies in mortgage-related structured finance and do not primarily reflect fundamental weaknesses in the risk management and infrastructure of the CDS market. In addition, the development of CDS referencing mortgage-related securities was more of an effect than a cause of the rapid growth in mortgage-related securitization. The SEC’s exemptions to facilitate the central clearing and exchange trading of CDS seem desirable, although a significant portion of CDS transactions are unlikely to be improved by utilizing such venues. However, mandating central clearing is likely unnecessary to reduce CDS counterparty risk and may, in fact, increase counterparty risk to the extent a CDS clearinghouse unduly concentrates risk or undermines bilateral risk management. Counterparty risk management in the CDS market has generally been prudent, and systemically troubling CDS transactions arose from a small portion of the market involving financial guarantors and mortgage-related securities. The role of CDS in facilitating price discovery also suggests that prohibiting naked CDS or all CDS outright will decrease transparency in the credit markets. Ongoing reforms being undertaken by market participants under the supervision of the Federal Reserve Bank of New York to achieve greater transparency and stability call into question the extent to which additional regulation is necessary. Policymakers should act to prevent the concentration of CDS risk in regulated institutions, particularly when CDS are sold by insurance companies, purchased by banking institutions, or likewise utilized by such institutions’ unregulated subsidiaries. Reform of all CDS transactions at the instrument level does not seem warranted, however. Over-the-counter derivatives markets are in important ways superior to securitization in effecting risk transfer and thereby provide insights as to the most efficient and stable market microstructure for such purposes and the direction towards which financial modernization should take place. * Associate Professor of Law, New York Law School. B.A. 1998, University of California at Berkeley; J.D. 2002, University of Southern California. I would like to thank for comments Jerry Ellig and participants at the symposium “The Credit Crash of 2008: Regulation within Economic Crisis” sponsored by the Entrepreneurial Business Law Journal of the Ohio State University Moritz College of Law held on March 6, 2009, and Katelyn E. Christ for her invaluable research assistance. All errors are my own. This article originally appeared in the Working Paper Series of the Mercatus Center at George Mason University. GUILTY BY ASSOCIATION? REGULATING CREDIT DEFAULT SWAPS HOUMAN B. SHADAB TABLE OF CONTENTS Introduction...................................................................................................................................... 2 I. CDS Regulation and Reform ................................................................................................. 10 A. Federal Regulation and Oversight of CDS........................................................................ 10 B. Contract Law: ISDA Provisions and Auction Protocols ................................................... 12 C. Treasury Department OTC Derivatives Reform Proposals............................................... 14 D. Proposed Legislation Relating to Credit Default Swaps................................................... 14 E. SEC Exemptions to Enable CDS Central Counterparties.................................................. 17 F. SEC Exemptions to Allow Exchange-Traded CDS........................................................... 18 G. State Insurance Law Reform............................................................................................. 19 II. Assessment of CDS Reform Actions and Proposals ............................................................. 20 A. Credit Default Swaps: Market Characteristics and Practices............................................ 20 1. Mechanics and Contract Typology ............................................................................... 21 2. Market Size and Users .................................................................................................. 22 3. CDS Market Infrastructure............................................................................................ 24 B. Credit Default Swaps and the Financial Crisis.................................................................. 29 1. The Growth of Mortgage-Backed Securities................................................................. 29 2. Overconcentration of CDS Exposure: Monoline Bond Insurers................................... 33 3. Overconcentration of CDS Exposure: AIG................................................................... 35 C. Credit Default Swap Trade and Post-Trade Services Regulation...................................... 39 1. Mandatory Central Clearing.......................................................................................... 39 2. Exchange-Traded CDS ................................................................................................. 42 D. “Naked” Credit Default Swaps and Price Discovery ........................................................ 43 III. Conclusion ........................................................................................................................... 47 1 REGULATING CREDIT DEFAULT SWAPS GUILTY BY ASSOCIATION? REGULATING CREDIT DEFAULT SWAPS Houman B. Shadab INTRODUCTION The housing crisis, credit crunch, and ensuing international financial and economic downturn led a wide variety of U.S. policymakers to undertake actions intended to remedy deficiencies in the regulatory framework applicable to the U.S. derivatives markets. This Article examines recent significant regulatory and legislative actions relating to credit default swaps (CDS)1 in particular and offers a general assessment of the extent to which they are justified in light of the characteristics and dynamics of the CDS market and the role played by the instruments in the financial crisis. A CDS typically obligates a protection buyer to pay a quarterly fee to a protection seller in exchange for the seller compensating the buyer if an agreed upon reference obligation experiences a negative credit event, such as a loan being defaulted on, without requiring the protection buyer to actually own or otherwise be exposed to the risk of reference obligation. As part of a comprehensive plan for financial regulatory reform, on June 17, 2009 the U.S. Treasury Department proposed fundamental changes to the way all over-the-counter (non-exchange traded) derivatives are regulated, including CDS. The Treasury Department’s proposal seeks to mandate that standardized CDS contracts be cleared through a regulated central counterparty or traded on an exchange, prudential bank-like regulation of large CDS market participants, and enhanced transparency and recordkeeping requirements for all CDS transactions.2 Several bills introduced by Congressional lawmakers in 2009 also seek to enact reforms similar to those proposed by Treasury Department. Though not likely to be fully enacted into law, the bills also seek to enable the Commodity Futures Trading Commission (CFTC) to suspend trading in CDS,3 to require the CDS buyer to own the obligation referenced by the CDS (i.e., a ban on “naked” CDS),4 and an outright prohibition on all CDS.5 The Securities and Exchange Commission (SEC) also promulgated a series of exemptions to facilitate the central clearing and exchange-trading of CDS by approving the applications of private entities to engage in such activities without being subject to the full scope of SEC regulation applicable to clearinghouses