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Credit Default Swaps & Regulation

posted by Stephen Lubben

The administration has proposed new regulations that would move a substantial part of the extant CDS market onto exchanges and force clearing through central clearing agents.  This is fine, as far as it goes. The clearing agents will provide regulators with a window into this presently opaque market.

But what about the problem of offshoring?  That is, how do we know the market will continue in the same form?  And will the regulations allow for oversight of trading that might be moved to a foreign subsidiary? The proposal calls for reporting obligations for trades not cleared through a central agent -- the key will be to make sure that the reporting requirements are robust and extend to the affiliates of the regulated entity.

And what about the overbroad "safe harbors" in the Bankruptcy Code?


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Credit default swaps have three parties - the two who are making the bet and the legal establishment that is willing to enforce 'the deal' against the party that bet wrong.

Stop enforcing 'the deal' for offshore CDSs and that'll put a crimp in the trade.

Any comments or thoughts on novation practices? is this no longer an issue?

Novation presumably gets a lot easier if everything is on an exchange.

I worry that the exchange is going to itself be a too-big-to-fail institution that could prove to be financially vulnerable. Futures and options very rarely move quickly by the amount of the maintenance margins; credit default swaps can suddenly make big moves as a credit approaches default, but there will be no liquidity if margin requirements are too high. Within two or three business cycles, I think this exchange is going to be source of great heartburn.

We are not talking about evading regulation and laws we are talking about fraud, felony fraud and conspiracy to commit fraud by our largest financial institutions. There should be grand juries convened and indictments, trials and prison terms to follow.

First of all, a collaterized debt obligation is not secured or backed by collateral at all. A mortgage backed security is not backed by mortgage like protections under the law. A CDO is not backed by anything as a consumer loan is under the uniform commercial code, these are the initial two falsehoods or frauds from which the edifice of off balance sheet accounting arose.
How then did they get off balance sheet to permit more overly leveraged lending by the investment bankers? Easy, the big investment banks got AIG to market credit default swaps. These fraudulent insurance devices were backed by nothing.

AIG employees and the counterparty beneficiaries who benefitted from the governments ill considered bailout should be in front of a grand jury. Constructive trusts should be established to recoup the payouts.

To pick up on Mr. Lubben's thought to staunch "offshoring' : there are a wealth of precedents in securities and banking to give "extraterritorial reach" to make "ules" applicable to the U.S.regulated entity and its (foreign) affiliates.

Right now, the Fed and Gensler proposals are "damn good starts" but have too many potential gaps in them (we securities and derivatives lawyers love advising on "regulatory arbs" for our banking clients through these ever-shifting gaps to date).


SMTurns,Esq. NYC

Nor would it be much of a Legal stretch (personally I think none at all) for the SEC to promptly interpret all CDS as "securities" under the Securities Act -- and assert jurisdiction over the whole market -- period. (then hopefully figure out responsibly how to regulate it -- maybe jointly with the CFTC, assuming the regulatory turf war between the two agencies is finally over with).

More specifically, if put to the test, in light of underlying purpose, use and Huge TRADING MARKET in CDS -- the investment bankers' lawyers would be hard pressed to prevail in against the SEC deeming CDS "investment contracts" (Won't bore you all at this point with the Supreme Court case precedents on the matter).

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