Proposed Legislation to Regulate Credit Default Swaps and Other OTC Derivatives: Who Does Greater Market Transparency Benefit?

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There is a marked urgency in Washington to regulate Credit Default Swaps and other Over-the-Counter (OTC) derivatives. But to what do we owe this sense of urgency? Is it truly attributable to the oft-cited desire to protect unsophisticated consumers or is there a stronger impetus? The obvious objective of most efforts to regulate these swap agreements is to achieve greater transparency through a central clearinghouse. Given the high level of sophistication of most counterparties to such transactions, perhaps the lack of transparency disadvantages government, or the nation's taxpayers, more than it does supposed unsophisticated counterparties to swap agreements or for that matter, any aggrieved party to a swap agreement-regardless of the level of sophistication or market familiarity.

The stress around the CDS market reached a pinnacle a little more than a year ago in September 2008 when the federal government provided American International Group Inc. (AIG) with roughly $182 billion in cash as a bailout to stave off insolvency, reasoning that the insurance giant was too large and too central to fail. The source of AIG's financial debacle was rooted in its sales of CDS contracts beginning around 1998. AIG participated in the market heavily as a seller of protection and seldom served as a buyer of protection. This imbalance paired with a lack of due attention paid to market risk was the catalyst for AIG facing insolvency unless it found a way to pay off amounts due to CDS counterparties who had suffered heavy losses. More than a year after the AIG bailout, there remain questions around the bailout arrangements and the House of Representatives seeks a hearing with Sec. Timothy Geithner to more clearly understand what transpired.

Credit Default Swaps in General

CDS are among the types of OTC derivatives that two counterparties negotiate to contract for transfer of a credit risk. In this way, a CDS is like an insurance contract on a financial instrument, insuring against the risk of default on the underlying asset or reference obligation. Under the terms of a CDS, a buyer of protection provides the seller of protection with a payment-either a periodic or a one-time payment. In exchange, the seller of protection agrees to pay a settlement amount to the buyer upon the occurrence of a credit event related to the underlying reference obligation which is guaranteed by the reference entity. To complicate the CDS market, there is no requirement that either the buyer or the seller of protection have an interest in the underlying reference obligation. In other words, CDS agreements may be categorized as either covered swaps or naked swaps. Under the terms of a covered swap, the buyer of protection has an interest in the reference obligation and enters into the contract to hedge against risk of loss if the reference obligation defaults or if the reference entity that issued or guaranteed the reference obligation becomes insolvent. By contrast, a naked swap represents the host of CDS contracts in which the buyer of protection does not hold any interest in the underlying reference obligation but uses the CDS as an instrument to speculate on the future performance or creditworthiness of the reference entity.

Speculative derivatives grow larger than the value of the underlying reference obligation (bond, loan, or security) to amplify the risk. Although the reference obligation is typically municipal bonds or corporate debt, this category has expanded to structured debt such as derivatives used to structure collateralized debt obligations (CDOs). As the CDS contracts continue to evolve between counterparties who are further and further removed from the reference entity and ownership of the reference obligation, market participants have incentives keep the market opaque and disguise true credit exposure. Because many CDS contracts arrange for a cash settlement and because defaults by sellers of protection have grown more prevalent, these OTC derivatives are the recipients of increased attention and scrutiny.

A Lack of Current Regulation for OTC Derivatives

Currently OTC derivatives are generally unregulated by federal securities and commodities law due to a number of exemptions. In addition, although states like New York have proposed regulating credit default swaps as a form of insurance, there is not presently state legislation in effect, in part because states are waiting to see what develops at the federal level.[1] Beyond that delay, it appears problematic that states would begin to regulate CDS contracts as insurance because those efforts would only address covered swaps to the exclusion of naked swaps which cannot accurately be categorized as insurance. Under this model, the federal government would still have responsibility to regulate naked swaps. The lack of federal or state regulation of CDS and other swap agreements has left aggrieved counterparties with causes of action based on contract law. Litigation has arisen, and will likely continue, over the technical definition of a credit event.[2] Exactly what constitutes a credit event to trigger the right of protection is dependent on the specific contract terms. Failure to pay is the most common credit event. Under the International Securities Dealers Association 2003 Credit Derivative definitions (ISDA)[3], other examples of credit events include bankruptcy, a change in interest rate, a change in principal amount, postponement of interest or principle payment date, a change in ranking of priority, and a change in currency of payment of interest or principal in a non-permitted currency.

Recent Efforts to Regulate OTC Derivatives at the Federal Level

During the spring of 2009, the Obama Administration released its white paper, "Financial Regulatory Reform: A New Foundation"[4] and less than two months later by June 2009, transferred the major tenets of its proposals into legislative text. The white paper identifies the following five key objectives: "(1) [p]romote robust supervision and regulation of financial firms"; "(2) [e]stablish comprehensive supervision of financial markets"; "(3) [p]rotect consumers and investors from financial abuse"; "(4) [p]rovide the government with the tools it needs to manage financial crises"; and "(5) [r]aise international regulatory standards and improve international cooperation." The white paper also proposes creation of a "Financial Services Oversight Council" which would be chaired by the Treasury.

In addition, there have been several bills introduced in the Senate and the House of Representatives to begin regulation of CDS and other OTC derivatives. Among these efforts at the federal level are: Credit Default Swap Prohibition Act of 2009[5]; Financial System Stabilization and Reform Act of 2009, introduced in the Senate[6] as well as in the House of Representatives[7]; Authorizing the Regulation of Swaps Act[8]; Derivatives Markets Transparency and Accountability Act of 2009[9]; Transparent Markets Act of 2009[10]; Let Wall Street Pay for the Restoration of Main Street Act of 2009[11]; Derivative Market Manipulation Prevention Act of 2009[12]; Derivative Trading Accountability and Disclosure Act[13]; Comprehensive Derivatives Regulation Act of 2009[14]; To enact the Over-the-Counter Derivatives Markets Act of 2009[15]; and The Wall Street Reform and Consumer Protection Act of 2009.[16] Efforts to enact legislation for regulation of swap agreements share common goals which include prevention of activity that creates excessive risk to the financial system, achieving greater transparency of risk exposure, preventing fraud, insider trading, and other abuses in the market, and protecting unsophisticated parties. A common proposal to address the unregulated OTC market is to establish a centralized clearing and trading system for swap agreements to mitigate risk.[17] Generally, under proposed legislation, standardized OTC derivatives would be centrally cleared through either a Commodity Futures Trading Commission (CFTC)-regulated exchange or through a Securities and Exchange Commission (SEC)- regulated exchange or an alternative swap execution facility regulated by the CFTC or the SEC. In addition, comprehensive legislation would address non-standardized OTC derivatives by establishing higher capital and margin requirements to promote increased use of standardized derivatives and encourage migration into the central clearing exchanges.

One Bill in Particular: Authorizing the Regulation of Swaps Act

To better understand some of these federal efforts to regulate CDS and other swap agreements, this article takes a closer look at a specific bill titled "Authorizing the Regulation of Swaps Act," which was introduced in the Senate in May 2009 by Senator Carl Levin and Senator Susan Collins. This comprehensive Bill proposes the repeal of prohibition on certain regulation of swap agreements as well as general oversight and regulation of swap agreements. If passed into law, the Bill would effectively remove all current exemptions for OTC derivatives under federal securities and commodities laws. The specific provisions that the Bill seeks to repeal affect the following acts: (1) the Gramm-Leach Bliley Act[18]; (2) the Securities Exchange Act of 1933[19]; (3) the Securities Exchange Act of 1934[20]; (4) the Commodity Futures Modernization Act of 2000[21]; (5) the Legal Certainty for Bank Products Act of 2000[22]; and (6) the Commodity Exchange Act.[23]

From a tactical standpoint, the Bill aims to make conforming amendments to current acts by replacing the term "security-based swap agreement" with "swap agreement" and by striking "or an exempt board of trade," "or operating as an exempt board of trade," as well as other specific subsections from current acts.[24] As a result of these proposed changes, the anti-fraud and anti-manipulation provisions contained within the Security Exchange Act of 1934 become applicable to CDS agreements and other OTC derivatives. The regulation and oversight proposed by this Bill is broad. Authority to regulate and oversee swap agreements is allocated among several "Federal financial regulators," which the Bill defines as including seven different regulators and reserves an eight "catch-all" category.[25] Each Federal financial regulator may oversee "any swap agreement that is entered into, purchased, or sold (or as to which the transaction, purchase, or sale is effected) by any financial institution, entity, or person (for its own account or for the account of others)" subject to the Federal financial regulator's jurisdiction or any swap agreement subject to the Federal financial regulator's jurisdiction.[26] Further, the Bill more specifically divides authority to oversee and regulate swap agreements between the SEC for swaps traded on the securities exchange and clearing agencies and the CFTC for swaps traded or cleared on the commodities trading facilities or registered entities.[27] Beyond this division, the Bill aims to achieve consistency among regulators by requiring that "[p]rior to taking action . . . each Federal financial regulator shall consult, work, and cooperate with other Federal financial regulators to promote consistency in the treatment of swap agreements."[28] This aspect of the Bill raises questions as to regulatory authority would effectively be split or shared among these named bodies because beyond granting authority to regulate and oversee expansively defined swap agreements, there is not specific definition of how the Federal financial regulators are to contour their collaborate regulation of swap agreements.


While the exact methods or results of federal regulation of CDS and other swap agreements remains uncertain, it is clear from the myriad of efforts in 2009 that these OTC derivatives will not much longer evade regulation under federal securities and commodities laws. So what would happen to the landscape of litigation around OTC derivatives, and CDS in particular, if Congress moves forward on proposed? The benefit of application of federal securities and commodities laws to swap agreements to plaintiffs is somewhat allusive. While it is true that complaints could theoretically thicken to include alleged violations of anti-fraud provisions such as those under the Exchange Act Section 10(b) and Rule 10b-5, the coup is less apparent where those causes of action are subject to a heightened pleading requirement and there already exists common-law fraud claims. In essence, the transparency gained from proposed establishment of the clearing agencies would provide the entrusted "Federal financial regulators," rather than unsophisticated counterparties, with the immediate benefits inherent to the ability to monitor who is participating in the market and at what level. Further, application of federal securities and commodities laws to OTC derivatives may raise more questions than it answers. Complications arise because the nature and character of these OTC derivatives vary so broadly. Much of the proposed legislation recommends splitting regulatory responsibility between the SEC and the CFTC. Confusion around regulatory responsibility and/or categorization of OTC derivatives will certainly translate into confusion around appropriate causes of action available to aggrieved parties of  various OTC derivatives.

Once federal legislation is in place to begin regulation, it will certainly take time to assess whether such regulation is effective or readily enforceable. But ultimately, whether or not it benefits litigants, regulation will improve transparency of the overall CDS and OTC derivative market by more closely monitoring these agreements, and therefore, monitoring arbitrage opportunities. With the clearing agencies as a filter, perhaps regulators will be able see more clearly imbalances in the market and place limits on activity to avoid repetition of recent history. In the interim, counterparties to CDS and other swap agreements should keep a watchful eye on the specific terms of their agreements, given the current lack of transparency for true credit exposure under these OTC derivatives and the rising risk levels of the market.

[1]In September 2008, New York's governor, David Paterson, announced that the state would begin regulation of CDS contracts in January 2009 through the New York State Insurance Department (NYSID). Among the goals of this regulation was to strictly limit financial guarantee insurers from guaranteeing CDOs. See Richard Kellerhals, NY Regulates CDS Market, Gov. Urges Fed. To Do Same, Bank Loan Report, Sept. 29, 2008. But the NYSID has since delayed its efforts to regulate CDS agreements pending new legislation at the federal level. See Leah Campbell and Robin Choi, State Initiatives to Regulate Credit Default Swaps Deferred Pending Federal Action, Metropolitan Corporate Counsel, Sept. 1, 2009 (citing Circular Letter 2008-19, Supplement 1).
[2] See, e.g., Aon Fin. Prod. v. Société Générale, No. 00 Civ. 5863GBD, 2005 WL 427535 (S.D.N.Y. Feb. 22, 2005) (entering judgment that default by the reference entity, Government Service Insurance System qualified as a credit event under the terms of the CDS contract).
[3]The ISDA 2003 Credit Derivatives Definitions available at 
[4] The white paper is available at
[5] H.R. 3145, 111th Cong. (2009)
[6] S. 664 111th, Cong. (2009)
[7] H.R. 1754 111th, Cong. (2009)
[8] S. 961, 111th Cong. (2009)
[9] H.R. 977, 111th Cong. (2009)
[10] H.R. 3153, 111th Cong. (2009)
[11] H.R. 4191, 111th Cong. (2009)
[12] S. 1682, 111th Cong. (2009)
[13] H.R. 3300, 111th Cong. (2009)
[14] S. 1691, 111th Cong. (2009)
[15] H.R. 3795, 11th Cong.(2009)
[16] H.R. 4173, 111th Cong. (2009)
[17] See, e.g., Derivatives Trading Integrity Act of 2009, S. 272, 111th Cong. (2009) (proposing amendment of the Commodity Exchange Act to ensure that there is a regulated exchange for all agreements, contracts, and transactions with respect to commodities).
[18] The Bill proposes to repeal sections 206A, 206B, and 206C of the Gramm-Leach Blily Act, 15 U.S.C. § 78c. S. 961, 111th Cong. § 2 (2009).
[19] The Bill proposes to repeal sections 2A, 17(d) of the Securities Exchange Act of 1933, 15 U.S.C. §§ 77b-1, 77q(d). Id.
[20] The Bill proposes to repeal sections 3A, 9(i), 15(i), 16(g), 20(f), and 21(A)(g) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78c-1, 78i(i), 78p(g), 78t(f), 78u-1(g). Id.
[21] The Bill proposes to repeal sections 301(b) and 304 of the Commodity Futures Modernization Act of 2000, Public Law 106-554; 114 Stat. 2763A-451, 2763A-457. Id.
[22] The Bill proposes to repeal sections 403, 404, and 407 of the Legal Certainty for Bank Products Act of 2000. 7 U.S.C. §§ 27a, 27b, 27e. Id.
[23] The Bill proposes to repeal portions of section 2, including subsections (d), (g), and the first two paragraphs of subsection (h), and section 5d of the Commodity Exchange Act, 7 U.S.C. §§  2, 7a-3. Id.
[24] S. 961, 111th Cong. § 5 (2009).
[25] The Bill defines "Federal financial regulator" as including:(i) the Commodity Futures Trading Commission; (ii) the Federal Deposit Insurance Corporation; (iii) the Board of Governors of the Federal Reserve System; (iv) the National Credit Union Administration; (v) the Office of the Comptroller of the Currency; (vi) the Office of the Thrift Supervision; (vii) the Securities and Exchange Commission; and (viii) any other Federal agency that is authorized under any provision of Federal law to regulate any financial institution or type or class of financial instrument or offering thereof. S. 961, 111th Cong. § 4 (2009).
[26] Id. § 3.
[27] Id. § 3(b).
[28] Id. § 3(c)(3)(d).

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