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By Fanni Koszeg at Bloomberg Law
“Every swap transaction is unique, like a snowflake, and you can't make snowflakes with a cookie cutter like the Commodity Exchange Act […] While many believe that the CFTC's actions may cause a financial crisis, no one believes that CFTC action is needed to solve one.” A representative of J.P. Morgan Securities, Inc. made this statement in 1998 when Congress assessed the CFTC's first efforts to regulate the over-the-counter (OTC) derivatives markets.1 Derivatives, including credit default swaps (CDS)--the instrument that caused JPMorgan Chase's recent $2 billion (and mounting2) trading loss--remained unfamiliar to the general public and unregulated for the decade that followed.
CDS entered public consciousness in the wake of the 2008 financial crisis with the massive bailout of AIG, the reputable insurance company. AIG had sold billions of dollars of credit protection, similar to insurance, in what proved to be risky CDS trades with some of the world's biggest financial institutions. Through the 2000s, the CDS market had grown significantly and became ever more dominated by speculation because, as one commentator put it, credit derivatives “often allow speculators to get the benefit of high leverage for very little initial outlay.”3 Synthetic collateralized debt obligations (CDOs), particularly deals that used credit derivatives to provide exposure to U.S. housing markets, arguably amplified the severity of the financial crisis of 2008.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) attempted to reform derivatives markets in general, including CDS, by bringing those markets into the open and reducing the risk they pose to the economy. As part of this effort, the so-called Volcker Rule is aimed at ensuring that systemically significant financial institutions (holding depositors' money and enjoying the government's implicit guarantee) do not engage in risky proprietary trading that could endanger their soundness and safety. Before his bank's trading loss, JPMorgan Chase's CEO Jamie Dimon argued that under the Volcker Rule, “if you want to be trading, you have to have a lawyer and a psychiatrist sitting next to you determining what was your intent every time you did something.”4JPMorgan Chase's CDS trading loss has demonstrated that it is not necessarily easy to draw a clear line between permitted hedging or trading on behalf of customers, and trading for profit, which would be prohibited. While the losses to JPMorgan Chase so far have not affected the bank's or the economy's stability, the incident revived discussions over the effectiveness of Dodd-Frank and whether systemically significant banks should be allowed to engage in complex, risky transactions whether described as “hedging” or “trading.”
While CDS markets have gone through a certain amount of standardization in recent years, CDS are still one of the complex instruments where it can be difficult to assess what purpose a particular trade serves. This article focuses on the evolution of CDS markets (and efforts to regulate them) from their inception through the U.S. financial crisis to the failed JPMorgan Chase trade. It also analyzes the role of CDS in financial markets and whether Dodd-Frank and regulators' efforts to implement the law are likely to bring about safer and more transparent markets.
If a credit event occurs, the payout amount is typically the difference between the original price of a specified amount of the reference obligation and its market value after the credit event, usually determined in an auction organized by the International Swaps and Derivatives Association (ISDA). This approach is known as “cash settlement.” Alternatively, “physical settlement” may apply, where the protection buyer delivers specified obligations to the protection seller, who typically then pays the original obligation price, making the buyer whole. The trades are typically confirmed under documentation published by ISDA and incorporate the 2003 ISDA Credit Derivatives Definitions. ISDA published the first set of definitions for CDS in 1999 with input from market participants. This helped establish standards and common terms for the then relatively new market and enabled market participants to confirm trades in a more efficient way, allowing the markets to grow at a faster pace.
Brooksley Born, then head of the CFTC, disagreed, and despite requests to hold off by the Department of the Treasury, the Federal Reserve, the Securities and Exchange Commission (SEC), and numerous industry representatives, the CFTC issued a Concept Release on OTC derivatives in 1998 to determine whether new regulation of the derivatives markets would be necessary given their rapid growth.8 The CFTC was in charge of overseeing OTC derivatives markets at the time and had granted exemptions for certain types of transactions not already exempted by the Commodity Exchange Act (CEA) itself from certain of its provisions. These exemptions did not cover CDS (or equity derivatives), and the CFTC's rationale in issuing the Concept Release was to ensure that the regulatory system was in tune with changes in the market.
In particular, the CFTC proposed to examine many of the themes that have subsequently become the cornerstone of financial reform such as clearing and exchange trading and the extension of recordkeeping and reporting requirements to new products to ensure transparency and prevent market abuse. In response, a bill was introduced in Congress to strip the CFTC of its authority to oversee swaps markets. Industry representatives voiced criticism that has since often been repeated in the context of efforts to regulate derivatives markets: banks are best at managing their own financial risks and the CFTC's attempt to explore regulatory proposals created legal uncertainty potentially reducing liquidity, efficiency, and imposing unnecessary costs. A representative of The Chase Manhattan Bank said at a congressional hearing on the bill that “if the legal uncertainty posed by CFTC assertions of jurisdiction is not removed Chase will be forced to move this business to another location, possibly London.”9 Congress was convinced by the industry's arguments, echoed by the Federal Reserve, the SEC, and the Treasury Secretary. The CFTC's regulatory authority over swaps markets was suspended, Born resigned, and Congress adopted the Commodity Futures Modernization Act of 2000 (CFMA), which broadly excluded financial derivatives from the CEA. Consequently, the financial industry got legal certainty that CDS would remain virtually unregulated.
The early 2000s also brought a wave of large credit defaults with WorldCom and Enron's failures and the financial crisis in Argentina. There was no major disruption to the CDS markets in the wake of these defaults, but market participants did not have an established procedure for post-trade settlement. At the time, ISDA was just beginning to devise standardized settlement practices. In 2009, ISDA established regional “determination committees” that are now in charge of establishing whether a credit event has occurred and auctions are organized according to a timeline set by the committees. Critics of the system argue that since the ISDA determination committees are dominated by the largest financial institutions and the language of ISDA documentation requires a lot of interpretation, other market participants' interests are not represented in the process.10
In the United Kingdom, by contrast, a number of regulators voiced concerns about the pace and complexity of innovation. The Bank of England's Deputy Governor, David Clementi, stated in a speech analyzing credit derivatives: “Unfortunately, however, where there is innovation, there are generally concerns… . From the point of view of financial stability, the concern is that these instruments might equally be used to concentrate risk as to disperse it.” (33 SRLR 409, 03/19/01). In 2002, U.K. Financial Services Authority Chief Howard Davies said in a speech that “the rapidly expanding market for credit derivatives was creating ’toxic’ risks for insurers who do not fully understand the complex financial instruments.” (34 SRLR 191, 02/04/02).
In the United States, in mid-2005, Timothy Geithner, as President of the New York Federal Reserve Bank, invited the biggest banks to discuss the rapid growth of CDS markets. The meeting focused on market infrastructure deficiencies, including a major documentation backlog and problems with post-trade settlement (37 SRLR 1527, 09/19/05). (The SEC and the Office of the Comptroller of the Currency (OCC) were invited to the meeting, but the CFTC, later designated as the primary regulator for derivatives, was not.) In response, the biggest financial institutions (including JPMorgan Chase, Lehman Brothers, Bear Stearns, and Goldman Sachs) sent Geithner a brief letter pledging to clear up the documentation backlog and to move standard confirmations to the Depository Trust & Clearing Corporation (DTCC) system for automatic matching. A few months later, in February 2006, the NY Fed was “pleased with the progress” made by the banks in fulfilling their self-imposed operational improvement goals (38 SRLR 321, 02/27/06).
Despite stagnating and then decreasing housing prices in 2006-2007, banks continued to structure CDOs until mid-2007. As conditions further deteriorated many banks rushed to buy protection on their super senior securities but it became gradually clear that the majority of insurers would not be able to cover the losses. Many banks also purchased credit protection on AIG and other insurance companies that were counterparties in these CDOs. This may be viewed as sensible risk management, but also exemplifies the serious conflicts of interests that were characteristic of CDOs.13 The Bank of International Settlements showed strong growth in OTC credit derivatives, with outstanding CDS increasing by 36 percent in the second half of 2007 to $58 trillion notional amount (40 SRLR 870, 06/02/08). However, the report did not cover OTC trading in CDO instruments because of “the difficulty in collecting data on such trading.”
The complexity and lack of transparency of CDOs was one of the primary reasons why monoline insurers, investors, and even the banks who structured the deals, miscalculated the risks they entailed. In April 2007, the head of the European Central Bank, Jean-Claude Trichet, warned that “while useful instruments, credit derivatives could also create risks for the stability of the financial system unless certain conditions are met, principally, that risks must be accurately measured and priced, that risks must be properly managed, and finally, that there always must be sufficiently diverse behavior and risk appetite among investors to assure the system remained liquid” (39 SRLR 670, 04/30/2007).
Ultimately, the federal government bailed out AIG, and the company paid 100 cents on the dollar to its bank counterparties for the protection it sold. Most of the monoline insurers, however, went out of business and the large dealers remained exposed to their credit risk and had to take “significant but hard-to estimate charges.”14
The involvement of AIG and other insurers in these transactions seems to be a perfect example of internal controls gone wrong all around. While, arguably, the banks diminished their subprime losses somewhat by collecting on some of their insurance, it may also be true that if these deals had not been put together in the first place then this added layer of very real losses suffered from purely or partly synthetic structures could have been avoided. Accordingly, the CDO market is also a good lesson in why more volume in a very concentrated and essentially illiquid and opaque market coupled with a lack of effective risk management can have extremely negative consequences and the mantra of “financial innovation and growth is good” should not always apply (39 SRLR 1829, 12/03/2007).
Eventually, DTCC's trade information warehouse “became a centralized global database of virtually all CDS contracts outstanding in the marketplace.”16 Trade details are still private information, it is not possible to see individual firms' exposures, but weekly data on the aggregate amount of outstanding CDS protection adds some transparency to the previously completely opaque markets.
Many of the Dodd-Frank rules have yet to be finalized and both the SEC and CFTC have missed many of their rulemaking deadlines. Notably, the controversial Volcker Rule has not been implemented (although some financial institutions have already spun-off their proprietary trading desks in anticipation). An academic expert warned in a 2010 study that the major dealer banks dominating derivatives markets have “a very strong financial incentive to resist and the ability to delay or impede changes from the status quo even if the legislative reforms that are now being widely discussed are adopted-- that would make the CDS and eventually other derivatives markets safer and more transparent for all.”18 Most banks continue to lobby against the rule and recent efforts in Congress to cut the CFTC's budget indicate that regulators may be left without necessary funding to best carry out rulemaking duties and provide effective oversight.
The bank's Chief Executive Officer, Jamie Dimon, contended that the trade, a large book of CDS on an index, was a “portfolio hedge” which subsequently “morphed into something that, rather than protect the Firm, created new and potentially larger risks.”19 However, critics argue that these “economic portfolio hedges” are not really hedges at all, do not correlate with any identifiable risks, and should not be allowed under the Volcker Rule.20
Nonetheless, Dimon, who had become the “public face of Wall Street's opposition to the Volcker Rule”, maintained that the rule was “unnecessary” and would have negative consequences for the U.S. financial system and would potentially restrict his bank's market making activities which is crucial to save money for ordinary investors.22 On the other hand, representatives of an independent industry organization have argued that the current proposals put regulators in a difficult position and “regulators would be forced to reconstruct history to counter claims by traders and their lawyers that their money-making positions really were necessary inventory or hedges.”23 In the case of complex CDS trades, the regulators could have a particularly difficult time monitoring and assessing the motives of traders who have a significant informational and expertise advantage. It remains to be seen what the final rule will look like, but, on the upside, “if, as currently drafted, the Vocker Rule would have allowed the trades, it should be refined. There's still time: Thanks to banks' opposition, the rule has yet to be finalized.”24
2See, e.g., Ambereen Choudhury and Dawn Kopecki, JPMorgan Slips on Report Trading Loss Widened to $9 Billion (Jun. 28, 2012),http://www.bloomberg.com/news/2012-06-28/jpmorgan-slips-on-report-of-trading-loss-widening-to-9-billion.html.
3See Janet Tavakoli, Greece and Credit Default Swaps: Bucking the ISDA Cartel (Mar. 2, 2012), http://www.huffingtonpost.com/janet-tavakoli/greece-credit-default_b_1318338.html.
4See, e.g., Ben Protess: Jamie Dimon Shows Some Love for Volcker Rule (May 21, 2012), New York Times, http://dealbook.nytimes.com/2012/05/21/jamie-dimon-shows-some-love-for-volcker-rule/.
5 A recent report by the International Organization of Securities Commissions (IOSCO) found that “CDS have an important role in the price discovery process on credit risk and that the inception of CDS trading has a negative impact on the cost of funding for entities of lower credit quality. To date, there is no conclusive evidence on whether taking short positions on credit risk through naked CDS is harmful for distressed firms or high-yield sovereign bonds.” Report available at:http://www.iosco.org/library/pubdocs/pdf/IOSCOPD385.pdf.
6 The J.P. Morgan Guide to Credit Derivatives (with contributions from the RiskMetrics Group), available at:http://www.investinginbonds.com/assets/files/intro_to_credit_derivatives.pdf.
7 For an account of regulatory conflicts on derivatives see e.g., Peter D. Goodman, Taking a Hard New Look at a Greenspan Legacy, New York Times (Oct. 8, 2008), available at:http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?_r=2&pagewanted=1.
8The Financial Derivatives Supervisory Improvement Act and the Financial Contract Netting Improvement Act: Hearing on H.R. 4062 and H.R. 4239 Before the H. Comm. On Banking and Financial Services, 105th Congress (July 17, 1998) (statement of Brooksley Born, Chairperson of the Commodity Futures Trading Commission).
11 For a comprehensive overview of AIG's CDS portfolio, risk management failures, and bailout under the Troubled Asset Relief Program (TARP) see Congressional Oversight Panel, The AIG Rescue, Its Impact on Markets, and the Government's Exit Strategy (June 10, 2010) available at:http://cybercemetery.unt.edu/archive/cop/20110402010341/http://cop.senate.gov/documents/cop-061010-report.pdf.
12 A study published by ISDA in 2011 entitled “Counterparty Credit Risk Management in the US Over-the-Counter (OTC) Derivatives Markets, Part II - A Review of Monoline Exposures” was a follow-on to a previous ISDA study analyzing losses incurred in the US banking system due to counterparty defaults on OTC derivatives. According to the study, in contrast to the OCC's estimate for bank losses due to exposure to monoline insurers of $2.7 billion, the total is likely to amount to as much as $21 billion.
13 Several SEC enforcement actions involving CDOs against large banks, including JPMorgan Chase, Goldman, Sachs & Co., and Citigroup Global Markets, Inc., were in part based on the banks' failure to disclose such conflicts of interests. For a comparative analysis of three prominent regulatory actions see, e.g., Tatiana Rodriguez, Apples to Apples? A Comparison of Recent SEC Enforcement Actions Involving CDOs, Bloomberg Law Reports®--Securities Law (Nov. 17, 2011).
15 Darrell Duffie, Policy Issues Facing the Market for Credit Derivatives (Apr. 30, 2009),http://www.darrellduffie.com/uploads/policy/DuffiePolicyIssuesCreditDerivatives2009.pdf.
16 An explanation of DTCC's trade information and links to public data can be found at:http://dtcc.com/products/derivserv/suite/ps_index.php.
17 For a good summary of Dodd-Frank's potential implications for CDS see, e.g., Eric J. Peterman, Heath P. Tarbert, and Quiong Sub, Weil, Gotshal & Manges LLP, The Dodd-Frank act and Credit Derivatives: A Market Transformed,http://www.bloomberglaw.com/securities/document/X3GOLDG106110040000H4?summary=yes#jcite.
19Examining Bank Supervision and Risk Management in Light of JPMorgan Chase's Trading Loss, Hearing Before the H. Comm. on Financial Services,112th Congress (Jun. 19, 2012) (statement of Jamie Dimon, Chairman & CEO, JPMorgan Chase & Co.). For a timeline and overview of the failed trades, see Erik Schatzker, Dawn Kopecki and Bradley Keoun, House of Dimon Marred by CEO Complacency Over Unit's Risk (Jun 12, 2012), Bloomberg News,
20See, e.g., Peter Coy, The Hubris of Jamie Dimon (May 17, 2012), (“it's important to create a bright line between legal trades and illegal ones […] One way to do that would be to do something Dimon doesn't want: rule out all hedge trades except those where there is a clearly identified asset to be hedged on the other side”),http://www.businessweek.com/articles/2012-05-16/the-hubris-of-jamie-dimon#p3.
22 Steven Sloan and Silla Brush, Dimon Gives Regulators New Ammunition for Tougher Volcker Rule (June 13, 2012), Bloomberg News,http://www.businessweek.com/news/2012-06-13/dimon-gives-regulators-new-ammunition-for-tougher-volcker-rule.
23 Dennis Kelleher and Mark Jarsulic, Ban Prop Trading Under Other Names (May 25, 2012), Bloomberg View, http://www.bloomberg.com/news/2012-03-25/ban-prop-trading-under-other-names-kelleher-and-jarsulic.html.
24 Bloomberg View Editorial, Five Questions for Jamie Dimon (Jun. 12, 2012),http://www.bloomberg.com/news/2012-06-12/five-questions-for-jamie-dimon.html.
25See, e.g., National Public Radio, Could Glass-Steagall Have Stopped JPMorgan Loss? (May 21, 2012), http://www.npr.org/2012/05/19/153095800/could-glass-steagall-have-stopped-jpmorgan-loss; see also The Small Business Authority, Bring Back Glass Steagall (May 14, 2012), Forbes,http://www.forbes.com/sites/thesba/2012/05/14/bring-back-glass-steagall/,
26 Bloomberg View Editorial, Making Banking Boring Won't Make It Safer (Jun. 10, 2012), Bloomberg View, http://www.bloomberg.com/news/2012-06-10/making-banking-boring-is-the-wrong-way-to-make-it-safer.html.
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