Perspectives: The Regulatory Scramble over Credit Default Swaps Begins

By Alyn Ackermann
February 2, 2009

OLDWICK, N.J., Feb 02, 2009 (A. M. Best via COMTEX) -- AIG  -- It looks as though Washington has finally been prodded into conjuring some regulatory oversight of the derivatives markets, including the credit default swap contracts that have played so prominent a role in the near-collapse of American International Group.

Media accounts indicate that members of Congress and federal regulators are stoked up to cage the derivatives beast. But when it comes to credit default swaps, there still seems to be a question about what kind of critter we're dealing with.

Most of the regulatory ideas look at CDS as securities for instance, monitoring them by requiring they be sold on an exchange or through a central registry.

But the National Conference of Insurance Legislators held a hearing in New York on Jan. 24 to ask a different question: Are CDS contracts really risk-transferring insurance products, and should state insurance regulators be overseeing them?

After five hours of testimony, the answer seems to be -- maybe.

A credit default swap is a contract based on an underlying financial product. In exchange for a premium, the seller of the CDS commits to paying an agreed-to amount in case of a default by the issuer of the product.

Simple, right?

'I don't think anyone can dispute that when you have that obligation, then you are buying insurance,' New York Insurance Superintendent Eric Dinallo said at the hearing.

Well, actually, quite a few people do.

Nat Shapo, the former Illinois insurance director, who appeared at the hearing on behalf of the National Association of Mutual Insurance Cos., told the NCOIL panel that a CDS contract doesn't meet the commonly accepted legal definition of insurance because it is a contract between parties that does not involve the pooling of risk.

Insurance, securities, even banking regulations, have been suggested as the proper control for the CDS market. NCOIL has said it will be considering the issue this year.

But there is one aspect of the CDS market that is drawing considerable focus from would-be regulators, insurance and otherwise the absence of risk.

When they started as a protective device by banks, for banks, written to cover interbank dealings, the NCOIL panel was told credit default swaps were pretty basic. Later, they were bought by owners of bonds or other financial products as a hedge against default by the issuer. Still basic.

But then credit default swaps became a way of betting on the market: You buy a CDS to bet that the company putting out a bond issue, for instance, will default. You have no direct exposure to the default risk.

NCOIL, and federal officials, have been told that as much as 80% of all CDS contracts are for buyers who have no direct exposure to the default risk so-called naked credit default swaps. One draft bill floating around Congress would outlaw naked credit default swaps entirely.

What Dinallo termed a similar kind of trading was outlawed a century ago by the 1909 New York state law banning 'bucket shops', where security or commodity futures were sold but no transaction was ever made on an exchange. The law grew out of the bank panic of 1907 also a credit crisis and was copied by other states.

The Commodity Futures Modernization Act of 2000, however, preempted state laws and essentially deregulated certain derivative transactions, including credit default swaps.

'This was intentional', Dinallo said -- 'legal advisors for the big players in the financial markets saw the direction of derivatives activity in the late 90s and grew concerned that it was violating the bucket shop law'.

'Somebody understood it, otherwise they wouldn't have asked for that safe harbor they wouldn't have asked for the preemption,' he told the NCOIL panel.

And if the safe harbor is blown upDinallo and others say the remaining 20% of the CDS market should be regulated outright as insurance; his department had intended to do just that beginning Jan. 1, but backed off to see what federal regulators would do.

Others still argue for securities or other regulation.

It seems that regulators are going to try getting into the CDS market in a big way this year -- and the market players, no doubt, will be trying to wriggle out from under them.

The CDS-as-insurance debate will be in the mix. Stay tuned.

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