Joint Federal-State Credit Default Swap Investigation Is Launched
By Irene C. Freidel and Anthony R.G. Nolan
The U.S. Attorney’s Office in Manhattan and the New York Attorney General’s Office confirmed last week that they have launched a joint investigation into operation of the largely unregulated $55 trillion dollar market for credit default swaps (“CDS”).
CDS are synthetic risk transfer devices whereby, in exchange for a premium, one party (the seller) agrees to make a payment to the other (the buyer) to protect the buyer from credit risk of one or more reference entities following the occurrence of a bankruptcy or other credit event with respect to such reference entity. Following the occurrence of a credit event, the buyer is entitled to receive a cash payment to compensate it for the decline in market value of selected obligations of the reference entity. Therefore, the value of a CDS to the buyer fluctuates with changes in the reference entity’s financial strength, increasing as the reference entity’s creditworthiness deteriorates and decreasing as the reference entity becomes more financially stable.
Since 2005, the CDS market has become very large and liquid, with an estimated $62 trillion notional amount of CDS outstanding globally in 2007. The growth of the CDS market has been premised to a great extent on light regulation of CDS transactions under commodities laws, securities laws, and insurance law. Most CDS are “security-based swap agreements” that are excluded in large part from SEC jurisdiction, although they are subject to antifraud and antimanipulation provisions of the U.S. federal securities laws.
The current investigation represents an expansion of existing investigations by federal and New York State authorities into whether short-selling activity resulted in manipulation of the price of bonds and shares of financial services institutions. The purpose of the current effort is to determine whether investors manipulated the prices (or credit spreads) of CDS in uncompleted transactions that were nonetheless reported to data providers. Credit spreads for CDS affect the prices of the debt obligations issued by entities referenced in the CDS because those spreads are considered to be leading indicators of perceived financial stability of the reference entity. Thus, efforts to manipulate CDS pricing could benefit short sellers of financial obligations issued by the reference entities, who would benefit from a decline in the value of those obligations occasioned by fears that the reference entity might be under financial stress.
Collaboration of the two enforcement offices suggests that the investigation will be significant and wide-ranging in scope, and includes the possibility that U.S. Attorney Michael Garcia will seek information from foreign sources. To date, subpoenas have been issued by New York’s Attorney General Andrew Cuomo to a variety of large financial institutions, including stock exchanges, hedge funds, and several entities that are involved in the credit default swap trade process: Depository Trust Clearing Corp., Markit, and Bloomberg LP. Whether the investigation will result in any prosecutions is as yet unknown. The effort reflects a new aggressiveness in the use of antimanipulation enforcement jurisdiction to the derivatives market.
