Regulation of CDS market ‘will be counterproductive’

SEC chairman Christopher Cox’s calls for regulation of the CDS market do not find favour with industry commentators

WASHINGTON, DC – In a prepared statement to the Senate Banking Committee yesterday, the chairman of the US Securities and Exchange Commission (SEC), Christopher Cox, indicated the problems caused by the non-regulation of the $58 trillion credit default swaps market.

Cox said: “The $58 trillion notional market in credit default swaps … is regulated by no-one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market.” He went on to compare CDS buyers with short sellers. “Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instruments upon which a CDS contract is based. This means CDS buyers can ‘naked short’ the debt of companies without restriction. This potential for unfettered naked shorting and the lack of regulation in this market are cause for great concern.”

As a result, Cox called on Congress to “provide in statute the authority to regulate these products to enhance investor protection, and ensure the operation of fair and orderly markets”.

Robert Claassen, a derivatives expert and partner at international law firm Paul Hastings, says: “I'm concerned that any reactive regulatory efforts would be counterproductive, and potentially drive the market offshore to London and Hong Kong. At the end of the day, the SEC does not currently have direct jurisdiction over the vast majority of CDS transactions, because they are not securities.”

He added: “Any effort for the SEC to limit the types of entities or regulatory status of entities entering into CDS transactions could be counterproductive or impose additional disclosure obligations on the trades themselves, and could serve to increase the cost of entering into these transactions.”

The fragmented financial regulation system in the US could also, Claassen warns, lead to turf wars in the effort to regulate CDS transaction. “The fear is that, with the rush to regulate, different parts of the CDS market will be under the jurisdiction of different regulators, resulting in a hodgepodge of regulation that could make it more difficult for these transactions to happen in the US, driving the market offshore.”