October 23, 2008
The Gibson, Dunn & Crutcher Financial Markets Crisis Group is tracking closely government responses to the turmoil that has catalyzed dramatic and rapid reshaping of our capital and credit markets.
We are providing updates on key regulatory and legislative issues as well as information on legal issues that we believe could prove useful as firms and other entities navigate these challenging times.
This update focuses on recent calls for regulation of credit default swaps.
Overview of Credit Default Swaps
Much attention recently is being paid to credit default swaps ("CDS"), which are derivative contracts between counterparties that transfer the risk of loss on credit instruments in the event of default in exchange for premium payments. In a typical CDS arrangement, a buyer agrees to pay premiums to a seller over a period of time to protect the buyer from the risks of a default on an underlying instrument—typically, municipal bonds or corporate debt. Although CDS are used in this way by investors to hedge risks from credit events, they are also used by investors to bet against credit events, such as bond defaults, because buyers of CDS are not required to own the underlying securities.
The volume of CDS has increased tremendously in the past few years. Although there is some dispute over the actual size of the CDS market, according to the International Swaps and Derivatives Association the volume of CDS has doubled every year since 2001, reaching $54 trillion as of June 30, 2008. [1] Many commentators, financial experts and politicians are blaming CDS, at least in part, for contributing to or exacerbating the current financial markets crisis, specifically problems experienced by Lehman Brothers, Bear Stearns and AIG. Although it is too early to tell exactly what problems CDS have caused or could cause (and to what extent), calls from both the public and private sectors for regulation and oversight are growing louder.
Existing Regulation of Credit Default Swaps
CDS are currently unregulated. Although CDS are subject to anti-fraud and similar provisions of the federal securities laws, these instruments are not considered securities or regulated as such. In 2000, the Commodity Futures Modernization Act ("CFMA") excluded CDS from the definition of "security" under the Securities Act of 1933 and the Securities Exchange Act of 1934 and barred the regulation of CDS and other derivatives. Further, the Securities and Exchange Commission ("SEC") has no legal basis to require reporting or disclosure on CDS market participants; Congress would need to intervene to give the SEC regulatory authority over the CDS market. [2]
State regulation of CDS is also limited as the CFMA barred most state regulation of CDS. And until recently, states have not been willing to view CDS as insurance products under state insurance regulatory regimes. For instance, the New York State Department of Insurance in the past has taken the position that the making of CDS does not constitute the "doing of an insurance business" under New York Insurance Law. [3]
Possible Regulation of Credit Default Swaps
On September 23, 2008, in testimony before the Senate Banking Committee, SEC Chairman Christopher Cox implored Congress to grant the SEC legal jurisdiction over the CDS market. On October 8, 2008, Chairman Cox publicly repeated this request, asking Congress to address what he called a "regulatory black hole." Although Congress has begun to focus attention on the CDS market, no legislative action has been taken. In addition to petitioning Congress to intervene, the SEC has separately responded to concerns that traders have used derivatives to short certain financial institutions and may have engaged in improper manipulative conduct. The SEC announced that it was expanding its ongoing investigation into possible market manipulation of the securities of those financial institutions. The SEC’s announcement stated: "Hedge fund managers, broker-dealers, and institutional investors with significant trading activity in financial issuers or positions in credit default swaps will be required, under oath, to disclose those positions to the Commission and provide certain other information." [4]
Officials at the SEC have suggested other remedial measures to rein in CDS. The SEC has proposed that creating a mandatory system of recordkeeping and reporting of CDS trades would reduce the possibility of fraud or market manipulation. [5] Another proposal is that CDS be exchange traded, which would add transparency and reduce liquidity risk by allowing parties to close out CDS positions at the best prices. [6] In an opinion piece in Sunday’s New York Times, Chairman Cox called on Congress to implement these proposals and asked that federal regulators also mandate the use of central counterparties for the CDS market. [7]
Other federal agencies are joining the SEC in calling for these regulatory proposals. The Commodity Futures Trading Commission ("CFTC") had proposed taking an oversight role in the late 1990s, but this role was opposed by Federal Reserve Chairman Alan Greenspan and others. [8]Recently the CFTC has again spoken out, joining the SEC in calling for the centralized clearing of CDS while Congress contemplates longer-term regulatory changes. [9] Centralized clearing could provide, among other benefits, a concentration of risk on one central counterparty. [10] The CFTC is in discussions with the SEC, the Federal Reserve Board and the Federal Reserve Bank of New York regarding the creation of such a central counterparty for CDS. [11] Eurex, NYSE Euronext, CME Group Inc. and IntercontinentalExchange Inc. have all been mentioned as possible counterparties.
It is likely that the most immediate impact could come from actions taken by the Financial Accounting Standards Board ("FASB"). On September 12, 2008, FASB issued a Staff Position amending FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities; this amendment requires sellers of credit derivatives, including CDS, to disclose certain information about those derivatives, thereby allowing users of financial statements to assess the derivatives’ possible effects on the seller’s financial position. [12] The Staff Position, which will be effective for reporting periods (annual or interim) ending after November 15, 2008, details a number of items which must be disclosed, including the nature of the credit derivative, the maximum potential amount of future payments the seller could be required to make and whether the seller might be able to recover any amount from third parties.
Finally, it is quite possible that various state agencies will attempt to regulate CDS or at least curb perceived abuses in the CDS market. As noted above, the CFMA bars most state regulation of CDS and other derivatives, but recently states have shown a growing interest in taking action. New York Governor David Paterson announced on September 22nd that his state’s Department of Insurance would begin classifying certain CDS transactions as insurance products and thus they would be subject to state insurance regulation. [13] Later in the same week, the New York state attorney general’s office expanded its short-selling investigation to encompass suspicious trading activity in the CDS market. It is expected that other states may follow New York’s lead.
The Future of the Credit Default Swap Market
As one commentator has noted: "With Washington suddenly in a frenzy of outrage over the financial markets, debating everything from the shape and extent of the mortgage plan to what should be done about short-selling, the future for CDS is very blurry. . . . The question is simply: What sorts of changes are in store?" [14] Industry groups, such as the International Swaps and Derivatives Association, continue to resist regulation and have supported the CFMA and other laws that barred the CFTC, the SEC and most state regulatory bodies from regulating CDS and other derivatives. In the current political climate, however, some form of regulation is likely inevitable and these groups’ resistance may be in vain. Representative Henry Waxman announced in early October that the House Oversight and Government Reform Committee would hold hearings this month "to examine the regulatory mistakes and financial excesses that led to the market breakdowns on Wall Street." [15] In a related hearing last week, Senator Tom Harkin pointed a finger at the CDS market, saying, "We now know this financial crisis and the collapse of key financial institutions owe a great deal to the extensive commerce in credit default swaps and similar contracts." [16] Senator Harkin has already announced that he would propose legislation that would provide greater transparency in the CDS market, including a proposal to move the trading in CDS to regulated exchanges. [17]
We will continue to monitor the situation in Washington and elsewhere. While it is still too early to tell what legislative or enforcement actions the federal and state governments will take, the time is now to begin informing those decisions before they are made.
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[1] See Nicholas Varchaver and Katie Brenner, The $55 Trillion Question, Fortune Magazine, October 13, 2008.
[2] See Testimony of Director Erik Sirri Concerning Credit Default Swaps, October 15, 2008, available at
[http://www.knowledgemosaic.com/gateway/Rules/TE.ts101508ers.101508.htm].
[3] See State of New York Insurance Department, Circular Letter No. 19 (2008), September 22, 2008, available at
[http://www.ins.state.ny.us/circltr/2008/cl08_19.pdf].
[4] See SEC Expands Sweeping Investigation of Market Manipulation, dated September 29, 2008, available at [http://www.sec.gov/news/press/2008/2008-214.htm].
[5] See Testimony of Director Erik Sirri Concerning Credit Default Swaps, October 15, 2008, available at
[http://www.knowledgemosaic.com/gateway/Rules/TE.ts101508ers.101508.htm].
[6] See id.
[7] Christopher Cox, Swapping Secrecy for Transparency, New York Times, October 19, 2008, available at [http://www.nytimes.com/2008/10/19/opinion/19cox.html].
[8] See Nicholas Varchaver and Katie Brenner, The $55 Trillion Question, Fortune Magazine, October 13, 2008.
[9] See Sarah Lynch, Key Senator Warns OTC Derivatives Industry About Regulation, October 14, 2008.
[10] See Sarah Lynch, Key Senator Warns OTC Derivatives Industry About Regulation, October 14, 2008.
[11] See Testimony of Director Erik Sirri Concerning Credit Default Swaps, October 15, 2008, available at
[http://www.knowledgemosaic.com/gateway/Rules/TE.ts101508ers.101508.htm].
[12] See Financial Accounting Standards Board Staff Position No. FAS 133-1 and FIN 45-4 (September 12, 2008), available at [http://www.fasb.org/pdf/fsp_fas133-1&fin45-4.pdf].
[13] See Governor Paterson Announces Plan To Limit Harm To Markets From Damaging Speculation, dated September 22, 2008, available at
[http://www.ins.state.ny.us/press/2008/p0809224.pdf].
[14] See Nicholas Varchaver and Katie Brenner, The $55 Trillion Question, Fortune Magazine, October 13, 2008.
[15] Tom Hamburger, Much Blame for Financial Crisis Aimed at Congresses Past and Present, Los Angeles Times, October 6, 2008, available at
[http://articles.latimes.com/2008/oct/06/business/fi-blame6].
[16] Sen. Tom Harkin, Statement on the Role of Financial Derivatives in the Current Financial Crisis, October 14, 2008.
[17] See Sarah Lynch, Key Senator Warns OTC Derivatives Industry About Regulation, October 14, 2008.
Gibson Dunn has assembled a team of experts who are prepared to meet client needs as they arise in conjunction with the issues discussed above. Please contact Michael Bopp (202-955-8256, [email protected]) in the firm’s Washington, D.C. office or any of the following members of the Financial Markets Crisis Group:
Public Policy Expertise
Mel Levine – Century City (310-557-8098, [email protected])
John F. Olson – Washington, D.C. (202-955-8522, [email protected])
Amy L. Goodman – Washington, D.C. (202-955-8653, [email protected])
Alan Platt – Washington, D.C. (202- 887-3660, [email protected])
Michael Bopp – Washington, D.C. (202-955-8256, [email protected])
Securities Law and Corporate Governance Expertise
Ronald O. Mueller – Washington, D.C. (202-955-8671, [email protected])
K. Susan Grafton – Washington, D.C. (202- 887-3554, [email protected])
Brian Lane – Washington, D.C. (202-887-3646, [email protected])
Lewis Ferguson – Washington, D.C. (202- 955-8249, [email protected])
Barry Goldsmith – Washington, D.C. (202- 955-8580, [email protected])
John H. Sturc – Washington, D.C. (202-955-8243, [email protected])
Alan Bannister – New York (212-351-2310, [email protected])
Adam H. Offenhartz – New York (212-351-3808, [email protected])
Financial Institutions Law Expertise
Chuck Muckenfuss – Washington, D.C. (202- 955-8514, [email protected])
Christopher Bellini – Washington, D.C. (202- 887-3693, [email protected])
Amy Rudnick – Washington, D.C. (202-955-8210, [email protected])
Corporate Expertise
Howard Adler – Washington, D.C. (202- 955-8589, [email protected])
Richard Russo – Denver (303- 298-5715, [email protected])
Dennis Friedman – New York (212- 351-3900, [email protected])
Stephanie Tsacoumis – Washington, D.C. (202-955-8277, [email protected])
Robert Cunningham – New York (212-351-2308, [email protected])
Joerg Esdorn – New York (212-351-3851, [email protected])
Stewart McDowell – San Francisco (415-393-8322, [email protected])
C. William Thomas, Jr. – Washington, D.C. (202-887-3735, [email protected])
Private Equity Expertise
E. Michael Greaney – New York (212-351-4065, [email protected])
Private Investment Funds Expertise
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Alan Samson – London (+44 20 7071 4222, [email protected])
Andrew Levy – New York (212-351-4037, [email protected])
Fred Pillon – San Francisco (415-393-8241, [email protected])
Dennis Arnold – Los Angeles (213-229-7864, [email protected])
Andrew Lance – New York (212-351-3871, [email protected])
Eric M. Feuerstein – New York (212-351-2323, [email protected])
David J. Furman – New York (212-351-3992, [email protected])
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Oscar Garza – Orange County (949-451-3849, [email protected])
Craig H. Millet – Orange County (949-451-3986, [email protected])
Janet M. Weiss – New York (212-351-3988, [email protected])
Tax Law Expertise
Arthur D. Pasternak – Washington, D.C. (202-955-8582, [email protected])
Paul Issler – Los Angeles (213-229-7763, [email protected])
Executive and Incentive Compensation Expertise
Stephen W. Fackler – Palo Alto (650-849-5385, [email protected])
Michael J. Collins – Washington, D.C. (202-887-3551, [email protected])
Sean C. Feller – Los Angeles (213-229-7579, [email protected])
Amber Busuttil Mullen – Los Angeles (213-229-7023, [email protected])
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