Saturday, April 10, 2010

CDS trial shows how connected markets are

Original posted in the FT by Aline van Duyn:

Nearly a year ago, the Securities and Exchange Commission brought its first case of insider trading involving credit default swaps, derivatives used to insure against defaults. This week, the case went to trial in a Manhattan court.

In it, a bond salesman stands accused of passing confidential information to a hedge fund manager. The salesman, Jon-Paul Rorech, worked for Deutsche Bank, which was in 2006 working on a high-yield bond issue for VNU. The SEC says Mr Rorech, who denies the charges, tipped off his client about changes to the Dutch publishing company’s debt offering.

The trial is expected to last for a few more weeks. The verdict, which will be decided by a judge and not a jury, will be a test of whether regulators can flex their muscles in the currently unregulated market for such swaps. New laws could bring greater scrutiny of this and other derivatives markets, with the SEC one of the key regulators in charge of policing them.

Regardless of the outcome, the trial provides a snapshot into just how connected markets are.

This is important: regulators and lawmakers are involved in a tussle with banks and investors over how much information about trading and pricing in privately-traded markets needs to be pushed into the public domain.

One reason is to track possible insider trading. Another is to spot the build-up of risks – such as AIG’s disastrous foray into credit default swaps.

“One of the challenges that we all will face in this case is trying to distinguish between the high-yield bond market, which is a unique market with unique practices, and the stock market, which we at least all have some, and some people perhaps have a lot of, familiarity with,” said Richard Strassberg, who is defending Mr Rorech.

He went on to describe the way bonds are sold. Investors in these risky companies are sophisticated professionals, who negotiate terms acceptable to them on new bonds. “There are no mom-and-pop stock buyers here,” he said. Mr Strassberg also went into detail about the specifics around the VNU bonds. The new bond offering was important in influencing prices of VNU credit default swaps. Mr Strassberg also explained that some other investors were looking at the bonds as a way to make arbitrage trades between bond prices and credit default swaps prices.

“The practice in the high-yield bond market is that there is a free flow of information that goes back and forth, back and forth,” Mr Strassberg explained. “None of that back-and-forth information is considered to be confidential by the market participants. None of the participants in a high-yield market believe that the back-and-forth negotiation and the discussions with the underwriters about what may happen is confidential.”

As Mr Strassberg highlighted, the practices in the high-yield market had implications for other markets – credit derivatives.

Investors know it is not enough to decide whether to buy Greece, VNU or Citigroup. They need to look across the whole capital structure and decide what to buy – a share, a bond, a subordinated bond, a convertible bond or a credit derivative.

Regulators need to see this whole picture too, because information in one part of the market clearly has knock-on effects on others. regulators have records of trading activity in stocks, which are traded through exchanges. They are now trying to catch up on getting trading information on other markets too, with dealers having to report trades in derivatives to information warehouses.

The debate about who should get what information, and when, will go on for years. However, the days where markets can thrive under the radar, in the way the high-yield and credit derivatives sectors did, are over.

At the very least, regulators should be able to get more information about trades, even if this is never made public. The laissez faire approach of the past decades has left an information vacuum and a dangerous gap in the understanding of markets between participants and regulators.

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