All Eyes On Credit Default Swaps
In recent months, credit default swaps ("CDSs") have been the subject of growing public scrutiny. As defaults by sellers of these instruments have risen, there has been a call for governmental regulation, increased disclosure and transparency, and investigation into possible fraud and market manipulation.
Those not intimately familiar with these popular and controversial financial instruments may be wondering how exactly CDSs work and why they are suddenly of such great concern to so many.
The following is a brief introduction to CDSs including an outline of the basic mechanics of a CDS, and a discussion of some recent proposals for regulation of the CDS market.
How Credit Default Swaps Work
A CDS is an over-the-counter negotiated contractual agreement between two counterparties designed to transfer credit risk. CDSs are often documented using standard forms and definitions prepared by the International Swaps and Derivatives Association ("ISDA") and may also include schedules and confirmations that set forth unique negotiated terms. The protection "Buyer" makes a fixed payment (either up-front or periodically) to the protection "Seller," and the Seller agrees to make a payment ("CDS Payment") to the Buyer under certain circumstances. The CDS Payment is paid if a specified event ("Credit Event")1occurs with respect to a specified company ("Reference Entity") that is unrelated to the Buyer or the Seller.
The fixed payment that the Buyer pays for a CDS is based on the market's perceived likelihood, at the time the CDS is purchased, that a Credit Event will occur. The cost of purchasing protection on a Reference Entity will fluctuate as, among other market factors, public opinion of the Reference Entity improves or worsens.
If a Credit Event occurs, the CDS Payment ultimately paid by the Seller is a function of a hypothetical principal amount ("Notional Amount"), and the current market value of a specified asset ("Reference Obligation")2issued or guaranteed by a Reference Entity at the time such Credit Event occurs. ISDA estimates that as of mid-2008, the aggregate Notional Amount of outstanding CDSs was approximately $55 trillion. It is worth noting that the Seller of a given CDS may in turn hedge its risk by purchasing a back-to-back CDS from another Seller on the same Reference Entity, subject to the same Credit Events; the second Seller may buy a third CDS from another Seller, and so on, in a continuing chain of risk reallocation. The netting out of risk through back-to-back CDSs makes the effective amount of outstanding CDS risk significantly lower than the $55 trillion aggregate figure implies.
Many CDSs are purchased by a Buyer with an interest in the underlying Reference Obligation (or, if the Reference Obligation is an index, securities similar to those such index comprises) as a hedge against the Buyer's risk of loss on such Reference Obligation; for example, if the underlying Reference Obligation suffers a payment default, or the Reference Entity goes into bankruptcy, the Buyer receives a CDS Payment. Such a CDS is called a "Covered Swap."
Additionally, a Buyer may purchase a CDS on a Reference Entity in which the Buyer does not hold any interest, in order to speculate (rather than hedge risk of loss) on the future creditworthiness of the Reference Entity (e.g., buying a CDS on a security issued by an entity in financial distress). Such a speculative CDS is called a "Naked Swap," and is distinguished from a traditional insurance policy, which is usually only purchased on an "insurable interest" (i.e., an asset in which the Buyer holds an interest). As the price of a CDS increases or decreases with the Reference Entity's condition, the Buyer can trade the CDS (via assignment).
In some cases, the Buyer of a CDS will require that the Seller post collateral in an amount sufficient to secure the Seller's obligation to pay the CDS Payment. The amount of collateral a Seller will be required to post under a CDS will be related, in part, to the likelihood of a Credit Event occurring (i.e., as a Credit Event becomes more likely, the Seller will have to post more collateral). However, the obligation to post collateral is a negotiated provision, and not a mandatory requirement of all CDSs. As a result, Buyers that did not negotiate collateral provisions have unsecured claims against their protection Sellers. Even when CDSs are drafted to permit Buyers to request collateral from Sellers, some Buyers fail to exercise that right.
Recent Calls For Increased Regulation, Disclosure And Investigation
Recent increases in Credit Events, collateral calls, and payment defaults under CDSs have triggered a number of proposals arguing for federal regulation of CDSs, and the institution of guidelines for increased disclosure and oversight.
The SEC - Conditional Exemptions, Exchange Trading and Central Counterparty Activities: On December 24, 2008, the SEC published two orders3establishing conditional exemptions from certain provisions of the Securities Exchange Act of 1934 ("1934 Act"). These exemptions allow exchanges, broker-dealers, and certain clearinghouse entities to engage in exchange trading and central counterparty activities with respect to standardized CDSs4 , without registering as national securities exchanges as long as they meet certain conditions including requirements regarding transparency, reporting and recordkeeping.5 The SEC's goal is to establish a central, unified clearinghouse for the sale of CDSs in order to reduce CDS counterparty risk and promote efficiency in the CDS market.6
The Senate and the CFTC - Bills Proposing a Central Clearinghouse: During the 110th Congress, a substantial number of bills were introduced that would have provided for some increased regulation of derivatives. Among these bills were S.3714, the "Derivatives Trading Integrity Act of 2008" ("DTIA"), introduced by Senate Agriculture Committee Chairman Harkin (D-Iowa) and S.3691, the "Financial Regulation Reform Act of 2008" ("FRRA"), introduced by Senator Collins (R-Maine), both of which responded to the concerns over the credit risks created by CDSs, and echoed the SEC's call for a central clearinghouse and increased disclosure. The two bills, neither of which was passed into law, reflected the continuing dispute in Congress and the private sector over what government agency is best suited to regulate CDSs: the DTIA looked to the Commodity Futures Trading Commission (the "CFTC"), not the SEC, to establish and regulate the clearinghouse, while the FRRA provided for a joint effort among the SEC, the CFTC and the Board of Governors of the Federal Reserve System to run the clearinghouse.
President Obama and Democratic and Republican leaders in Congress have indicated that financial market reform will be a priority in the early months of 2009, and we expect that versions of the DTIA and the FRRA will be reintroduced in the new Congress, along with other bills aimed at regulating CDSs to increase transparency and disclosure. We anticipate that Congress will pass, and President Obama will sign, a CDS regulation bill, either as stand-alone legislation or as part of a larger financial markets reform package.
Private Industry - Improved Public Information, Central Clearinghouse: On the private industry side, steps toward increased disclosure have already been taken by the Depository Trust and Clearing Corporation, which announced on October 31, 2008 that it would make weekly website postings of the gross and net values of CDSs for the top 1,000 Reference Entities. In addition, there is growing interest among many CDS dealers and end-users in establishing a central clearinghouse in which parties could clear and settle CDSs and that would eliminate counterparty credit risk. This idea is still evolving and further developments are expected.
Increased Accounting Disclosure Requirements: For public companies that are protection Sellers, increased accounting disclosure is already required pursuant to FASB Statement No. 133 and FASB Interpretation No. 45, in which the Financial Accounting Standards Board established broader disclosure requirements for reporting periods ending November 15, 2008 and beyond, including disclosure of the maximum CDS Payments potentially payable under a Seller's CDSs and the status of payment and performance risk thereunder.
SEC and NY Investigations into Fraud and Manipulation: Both the SEC's Division of Enforcement and a joint New York State and New York City taskforce have initiated investigations into possible market manipulation with respect to the CDS market. The investigations are continuing and it is unclear whether they will produce any significant enforcement actions or regulatory or other reform of the CDS market.
The Future Of Credit Default Swaps
The spotlight that has been turned on the CDS market in recent months has yielded a multitude of demands and proposals for government and private responses. Given the size and economic impact of the CDS market, in the current uncertain economic climate it is important that investors and market participants develop a better understanding of how CDSs work, what benefits and risks they involve, and how they may be regulated in the future.
1 Common examples of Credit Events include bankruptcy and payment default, but the parties to a CDS can contractually agree to name any Credit Events they wish .
2 Common examples of Reference Obligations include municipal or corporate bonds, collateralized debt obligations, mortgage-backed securities, and various indices based on such debt obligations.
3 The SEC issued the following Orders pursuant to Section 36 of the 1934 Act:
"Order Pursuant to Section 36 of the Securities Exchange Act of 1934 Granting Temporary Exemptions from Sections 5 and 6 of the Exchange Act for Broker-Dealers and Exchanges Effecting Transactions in Credit Default Swaps" ("Exchange and Broker-dealer Exemption"); and
"Order Granting Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection with Request of LIFFE Administration and Management and LCH.Clearnet Ltd. Related to Central Clearing Of Credit Default Swaps, and Request for Comments" ("CCP Exemption").
SEC Release No. 34-59165 (Dec. 24, 2008) and SEC Release No. 34-59164 (Dec. 24, 2008).
4 The security-based CDSs to be exchange-traded or centrally cleared and novated would be "standardized products"with standardized, rather than individually negotiated, specifications.These "non-excluded CDSs" subject to SEC regulation are in contrast to those individually negotiated CDSs that have been largely excluded from SEC's scope of authority.
5 The SEC has also approved, but not yet released, interim final temporary rules providing related exemptions under the Securities Act of 1933 and 1934 Act.
6 SEC Press Release 2008-303 (Dec. 23, 2008).
Thomas H. French is a Partner in the Corporate and Financial Services Department of Willkie Farr and Gallagher's New York office. Jack I. Habert is Special Counsel in the Corporate and Financial Services Departmentalso in New York. The authors wish to acknowledge associate Meredith B. Gordon for her assistance in preparing this article.