should cds be banned

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U.S. Draft Law Would Ban Most Trading in Credit Swaps (Update1)
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By Matthew Leising

Jan. 29 (Bloomberg) -- Draft legislation that would change how over-the-counter derivatives are regulated might prohibit most trading in the $29 trillion credit-default swap market.

House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota circulated an updated draft bill yesterday that would ban credit-default swap trading unless investors owned the underlying bonds. The document, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the $684 trillion over-the-counter derivatives market to be processed by a clearinghouse.

“This would basically kill the single-name CDS market,” said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California. “Given the small size of many issuers’ bonds outstanding, this would make it practically impossible for the CDS market to exist.”

U.S. regulators and politicians are stepping up pressure on banks to use clearinghouses and agree to increased oversight of the OTC markets to improve transparency amid the credit crisis. Bad bets on credit-default swaps led to the U.S. takeover of American International Group Inc. in September.

80 Percent

As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bonds, according to Eric Dinallo, superintendent of the New York Department of Insurance. Dinallo last year proposed outlawing so-called “naked” credit-default swap trading. He shelved the proposal in November because of progress by federal regulators on broader oversight of the market.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Proposals that would impair the credit-default swaps market “are likely to prove counterproductive to efforts to promote lending and return the credit markets to a healthy, functioning state,” said Greg Zerzan, the counsel and head of global regulatory policy at the International Swaps and Derivatives Association, which represents participants in the privately negotiated derivatives industry.

“This is a bad idea,” said Robert Webb, a finance professor at the University of Virginia and a former CME trader. “It is reminiscent of the opposition in the 19th Century to futures trading in the belief that speculators were controlling the market and driving agricultural prices down.”

European Reaction

European Union Financial Services Commissioner Charlie McCreevy said today he wouldn’t support a ban on trading credit- default swaps without owning the underlying bonds. Speaking in an interview at the World Economic Forum in Davos, Switzerland, McCreevy also said he favored creating a clearinghouse for OTC derivatives.

Forcing interest-rate swaps and credit-default swaps through a clearinghouse, which would establish prices for the privately traded contracts, may reduce how much banks are able to make from them.

As much as 40 percent of profit at Goldman Sachs Group Inc. and Morgan Stanley comes from OTC derivatives trading, according to CreditSights Inc. Estimating the new income that exchanges such as CME Group Inc. could earn from processing the OTC trades is difficult because clearing fees and volumes aren’t known yet, said Bruce Weber, a finance professor at the London Business School.

JPMorgan’s Holdings

JPMorgan Chase & Co. held $87.7 trillion of derivatives as of Sept. 30, more than twice as much as the next largest holder, Bank of America Corp., which had $38.7 trillion, according to data from the Office of the Comptroller of the Currency. Of the holdings at New York-based JPMorgan, 96 percent were in the OTC market, compared with 94 percent for Bank of America.

The largest positions at JPMorgan and Bank of America, based in Charlotte, North Carolina, were in interest-rate swaps. Banks enter into interest-rate swaps with clients such as cities or hospitals that sold bonds and seek protection against adverse moves in interest rates. They also hedge their exposure to rates in the inter-dealer market.

The OCC data only included U.S. commercial banks, so Morgan Stanley and Goldman Sachs Group Inc. weren’t listed at the time. Both New York-based investment banks converted to banks regulated by the Federal Reserve on Sept. 21.

Provision for Exemption

A provision in Peterson’s bill, which will be discussed in hearings next week, allows for the U.S. Commodity Futures Trading Commission to exempt certain OTC contracts that are too customized or don’t trade frequently enough to be cleared.

Funded by its members, a clearinghouse adds stability to markets by becoming the buyer to every seller and the seller to every buyer.

The standardization necessary to process a contract in a clearinghouse may harm the market and drive the trading overseas, Weber said.

“It’s a big deal because the OTC market has developed almost as an alternative to the exchange market with its clearinghouses,” he said. “It would be advantageous for places like London, Hong Kong or Singapore where OTC trading wouldn’t have that kind of restriction.”

Weber said that if price transparency is what Chairman Peterson wants, it can be achieved in other ways, such as putting OTC derivative prices on a system such as Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Peterson’s draft bill would also authorize a study by the CFTC to determine if OTC trading influences prices on exchange- traded contracts such as oil. If the commission found such an influence it would be authorized to set limits on the size of positions held by OTC traders.

 

I didn't even read the whole thing. The second parargraph already warned that the rest was going to be stupid.

Don't ban CDS's. Make the sellers maintain reserves for whatever they sell. model it after the regular insurance industry.

The assholes at AIG (et. al.) were selling the hell out of them, pocketing premiums, but never setting any capital aside. They figured if they bought one somewhere else their book would be zero VaR. Enter counterparty risk, and blam-o...

In a free and capitalist country the collapse of a counterparty would (concievably) lead to a chain of collapses of financial strain, teaching buyers the risk of counterparty failure. However in the country we live in, we print trillions dollars, and .... ah, nevermind. you know what we're doing...

There are EXCELLENT reasons for people to buy and sell CDS's that have nothing to do with whether they own bonds or not. trade partners, large stockholders, counterparties or stakeholders of any sort that want to hedge against a credit event.

Why take away a valuable tool, just becuase you can't somach the losses of those who wantonly use the to take on MASSIVE risk.

anyway, I'll quite ranting...

 

No, that would be the equivalent of telling people that buying home and auto insurance are no longer allowed. What does need to happen is for CDS contracts to be traded on a centralized exchange so that there is greater transparency.

 

Its like saying lets ban stock investing after the 90's bubble

 

Actually, it's more like telling people they can't buy auto, home, or life insurance unless they have an "insurable interest" in the subject of coverage.

Which, as it happens, is exactly how insurance works. Try buying insurance on your neighbor's home sometime.

There are plenty of ways to speculate, without needing to allow "naked" CDSs.

 

why wasn't even regulated to begin with.

these wall street fraudsters were selling insurance without an insurance license.

you can't sell insurance if you can't pay claims or have cash to pay claims.

 

The only Wall Street "fraudsters" that sold CDS and blew up is AIG.

And they have insuance license....

 

I would tend to agree with this view.

 

I'm sorry, but you have no idea what you are talking about. Besides, you didn't have to be a bank or an insurance company to buy/sell CDS securities.

 

Because there were a bunch of Republidan leglislators ( mostly from the Mid-West ) that sheparded this bill through the House and Senate without any debate or substantive policy committees.

It was a total "jam-job" at the end of the year in December of 2000; spearheaded by none other than Dick Lugar ( Indiana ), Pete Fitzgerald ( Illinois ), Phil Gramm ( Texas ), and Chuck Hagel ( Nebraska ) . . . conveniently put into the "Fiscal Year 2001 Appropriations Bill" for then President Clinton to sign and with virtually no chance of a veto given the "Appropriations Bill".

http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000

To me, this piece of legislation was the single most damaging to our financial system and Economy. You can talk all about Fannie and Freddie all you want, but given that there is $64 TRILLION in CDS exposure out there . . . this piece of legislation really takes the cake!

It also gave birth to the Enron online trading platform of power contracts ( that screwed the State of California in the Recessionof 2000-2001 ) along with the ICE trading of WTI crude overseas in Dubai and London with no CFTC oversight ).