How CDSs Came to Be Exempt from Anti-Bucket-Shop Legislation
With the growth of various kinds of derivatives in the late 20th Century, there was legal uncertainty as to whether certain derivatives, including credit default swaps, violated state bucket-shop and gambling laws. The Commodity Futures Modernization Act of 2000 (CFMA), signed by President Clinton on December 21, 2000, created a “safe harbor” by (1) pre-empting state and local gaming and bucket-shop laws, except for general antifraud provisions; and (2) exempting certain derivative transaction on commodities and swap agreements, including credit default swaps, from CFTC regulation.
CFMA also amended the Securities and Exchange Acts of 1933 and 1934 to make it clear that the definition of “security” does not include certain swap agreements, including credit default swaps, and that the SEC is prohibited from regulating those swap agreements, except for its anti-fraud enforcement authority.
So, by ruling that credit default swaps were not subject to state laws or SEC regulation, the way was cleared for the growth of the market. But there was one other issue. If the swaps were considered insurance, then they would be regulated by state insurance departments. If this were the case, then the capital and underwriting limits in insurance regulation would have curtailed the rapid growth in the market for these derivatives.
The Role of the New York Insurance Department
So, at the same time, in 2000, the New York Insurance Department was asked a very carefully crafted question. “Does a credit default swap transaction, wherein the seller will make payment to the buyer upon the happening of a negative credit event, and such payment is not dependent upon the buyer having suffered a loss, constitute a contract of insurance under the insurance law?”
Clearly, the question was framed to ask only about naked credit default swaps. Under the facts we were given, the swap was not insurance, because the buyer had no material interest and the filing of claim does not require a loss. However, the entities involved were careful not to ask about covered credit default swaps. Nonetheless, the market took the Department’s opinion on a subset of credit default swaps as a ruling on all swaps.
In sum, in 2000, as a society we chose not to regulate credit default swaps. Why did that matter? As we have seen, the financial system has been placed in peril because there was no comprehensive management of counterparty risk. Deals were made privately between two parties. These bilateral arrangements mean that there are no standards for the solvency of counterparties. The buyer does not know how much risk the seller is taking on. And there are no requirements for the seller to hold reserves or capital against the risks it is taking on by selling swaps.
None of this was a problem as long as the value of everything was going up, and defaults were rare. But the problem with this sort of unregulated protection scheme is that when everyone needs to be paid at once, the market is not strong enough to provide the protection everyone suddenly needs.
CDSs and Marking to Market
Unlike insurance, credit default swaps are marked to market. That means the value of the swap reflects the current market value, which can swing sharply and suddenly. Value changes require the sellers to post collateral. Sudden and sharp changes in the credit rating of the issuer of the bonds, or of the bonds themselves, can produce large swings in the value of the swaps, and thus the need to post large and increasing amounts of collateral. That capital strain can produce sudden liquidity problems for sellers. The seller may own enough assets to provide collateral, but the assets may not be liquid, and thus not immediately accessible.
When many sellers are forced to sell assets, the price of those assets falls and sellers are faced with taking large losses just to meet collateral requirements. As the prices of the assets are driven down by forced sales, mark-to-market losses increase, and the collateral posting cycle continues. Meanwhile, the underlying assets may continue to perform, paying interest and principal in full.
Steps to Bring CDSs under Control
On September 22, we announced that New York State would, beginning in January 2009, regulate the insurance part of the credit default swap market, which has, to date, been unregulated—the part which the Insurance Department has jurisdiction to regulate.
That announcement played an important role in spurring national discussion about a comprehensive regulatory structure for the CDS market. The result has been exactly what was envisioned—a broad debate and discussion about the best way to bring controls and oversight to this huge and important market, and concrete progress toward a centralized risk management, trading, and clearing system.
After our announcement, SEC Chairman Cox asked for the power to regulate the credit default swap market. The New York Federal Reserve began a series of meetings with the dealer community to discuss how to proceed. We believe that there are appropriate uses for credit default swaps.
We acknowledge that some amount of speculation can provide useful information and market liquidity. We also recognize that the best route to a healthy market in credit default swaps is not to divide it up among regulators. It would not be effective or efficient for New York to regulate some transactions under the insurance law, while other transactions are either not regulated or regulated under some other law. The best outcome is a holistic solution for the entire credit default swap market.