A draft bill that would toughen rules on credit default swaps could deprive investors of valuable risk-management tools.
Many of the draft bills provisions would disserve the very public interests by draining market liquidity, making hedging more costly and discouraging trading in the U.S., John Damgard, president of the Futures Industry Association, Washington, told a House Agriculture Committee hearing on Feb. 3.
Mr. Damgard was among several experts who testified over two days about the draft bill written by Rep. Collin Peterson, D-Minn., chairman of the agriculture committee.
A key provision bans naked credit default swaps in the over-the-counter market and allows them only on exchanges. Naked CDS are contracts taken by an investor not owning the underlying security. They have been blamed by some for playing a part, akin to shorting a stock, in the fall of Bear Stearns & Co. Inc. and Lehman Brothers Holdings Inc.
For instance, holders of naked CDS contracts on Bear and Lehman could sell off the securities to convey the sentiment of extreme financial stress on those institutions. Several analysts view the onset of the credit crisis as starting in the spring of 2007, when two Bear hedge funds collapsed because of subprime woes, starting the widening of spreads on Bear CDS.
According to a Jan. 7 analysis by Peter Wallison, a fellow at the American Enterprise Institute, Washington, although an estimated $72 billion worth of Lehman CDS were outstanding when the Wall Street firm filed for Chapter 11 protection from creditors last September, no financial group faltered. Despite speculation to the contrary, the woes of American International Group Inc., New York, were not caused by its exposure to Lehman CDS, which amounted to a paltry $6.2 million when all was said and done, Mr. Wallison further wrote.
Should the CDS market become disenfranchised, then the cost of funding via the primary capital markets will rise even further, as the ability to manage that risk for real money accounts will disappear, Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, Calif., said in an interview.
If the draft is introduced and passed, the legislation would profoundly change derivatives trading, both on futures exchanges and in the OTC market.
It also would require the Commodity Futures Trading Commission to set position limits for all financial futures contracts traded on exchanges, a task the markets currently handle.
The bill also requires central clearing of all OTC derivative transactions, except for specific exemptions a monumental task because most of the $684 trillion OTC market consists of individual contracts that cannot be standardized. According to June 2008 data from the Bank for International Settlement, the OTC behemoths are interest rate swaps, with a notional value of $460 trillion.