Wall Street's push to clean up a $10 trillion corner of the derivatives market is getting poor reviews from an important audience: global financial regulators.
Behind closed doors, watchdogs from Washington to London have made clear that a fix the industry came up with this year to crack down on shady deals falls short of what's needed, said people familiar with the matter. The focus of the scrutiny is credit default swaps — instruments tainted by the 2008 financial crisis that traders use to cash in when companies miss bond payments.
The pushback hasn't been subtle. Staff members at the Commodity Futures Trading Commission, the main derivatives regulator in the U.S., prepared an internal analysis in recent weeks that concluded hedge funds can still profit from CDS in numerous ways by engineering questionable corporate actions, three people said. The agency has shared its findings with other regulators.
In June, the U.S. Securities and Exchange Commission and the U.K.'s Financial Conduct Authority joined the CFTC in issuing a rare public statement in which the watchdogs pledged to work together to combat "opportunistic strategies" involving CDS. And the CFTC took the extraordinary step of hosting a July podcast for agency officials to discuss red flags they're seeing in the market, and how deals are proliferating with seven occurring in the past six months.
The change the industry proposed in March addressed situations where hedge funds have enticed stressed companies to miss bond payments they could otherwise make. But other trades continue to pop up, including instances of funds persuading corporations to alter debt terms to impact CDS prices.
For someone on the other side of a trade, such strategies can feel like manipulation that costs them a lot of money. That's because even minimal changes to companies' credit profiles can lead to substantial earnings in the CDS market, where valuations are based on the perceived likelihood of businesses defaulting or going bankrupt.
The heightened scrutiny — notable at a time when authorities are dialing back financial rules during the Trump administration — shows regulators are losing patience and might take action to force the industry to change its ways. At the core of their frustration: Wall Street seems to be resorting to increasingly creative ways once again to profit from CDS, instead of using the derivatives primarily for what they were initially created for — hedging bond investments against the risk of companies and governments defaulting.
"The SEC is working closely with the CFTC and the FCA to examine the various issues raised by the pursuit of manufactured credit events and other potentially manipulative strategies," the SEC said in a statement released by Chairman Jay Clayton's office. "SEC staff welcomes continued engagement with market participants on these matters."
Michael Short, a spokesman for CFTC Chairman Heath Tarbert, said that in certain circumstances, CDS trades can raise "critical questions of whether there is market manipulation, and we are looking very closely at it."
The FCA declined to comment.