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.
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