Friday, July 31, 2009

Derivatives plans spark doubt on CDS

Posted in the Financial Times by Sarah O’Connor:

A US legislative plan to regulate the near-$600,000bn market in over-the-counter derivatives suggests lawmakers debate the idea of banning so-called “naked credit default swaps”, which allow investors to speculate on the creditworthiness of companies.

The proposal by key committees of the House of Representatives would push most derivatives on to an exchange or clearing house but leaves open the issue of whether to outlaw CDSs – a type of insurance against bonds defaulting – in which the buyer does not own the underlying asset.

Congress is weighing how to regulate the opaque market as part of an overhaul of financial regulation that Barack Obama, president, wants to see completed by the end of this year. On Thursday the chairmen of the House financial services and agriculture committees, which share jurisdiction over the issue, released agreed principles that will form the backbone of legislation.

Collin Peterson, chairman of the agriculture committee, said they wanted to “err on the side of too much regulation rather than too little, given what we’ve been through.

“I think we have come up with a responsible approach that bridges the differences between those [House] members who want to completely eliminate the over-the-counter market, and those who think that just greater transparency is all that is needed. Neither of those approaches is a real solution.”

However, some criticised the plan for giving regulatory oversight of the market to both the Securities and Exchange Commission and the Commodities and Futures Trading Commission, with the creation of a council to resolve turf disputes.

“That sounds like a ­terribly ineffective way to regulate something, but it probably reflects the political reality,” said Gary DeWaal, senior managing director at New Edge, one of the world’s largest brokers.

“It’s like basically saying: you know what, we know mom and dad disagree on how to raise the kids, but a committee of the two sets of grandparents can have the final decision.”

The plan revealed some issues have not yet been decided. It suggests that one way to curb speculation in CDSs would be to ban so-called “naked” swaps. An alternative would require big market participants to reveal their short positions to their regulator and make them subject to position limits.

Cory Strupp, managing director for government affairs at the Securities and Financial Markets Association, said he was concerned about the idea to ban naked swaps. “When you take any particular subset of investors out of a market, you always reduce liquidity,” he said.

In line with a blueprint suggested by the Obama administration, the chairmen’s plan would try to shift as much of the market as possible on to exchanges. Exceptions would be made for contracts that are too customised to go through clearing or exchanges, but such contracts would be subject to “significantly higher capital and margin charges”.

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