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Portfolio > ETFs > Broad Market

Empire State Waits On Federal CDS Moves

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New York State Insurance Superintendent Eric Dinallo today told a congressional panel that his state will postpone plans to regulate part of the credit default swap market.

Members of Congress and members of the President’s Working Group on Financial Markets have shown a commitment to regulating the CDS market at the federal level, and to coming up with laws to support federal CDS market oversight, Dinallo said during a hearing organized by the House Agriculture Committee.

“Accordingly, New York will delay indefinitely our plan to regulate part of this market,” Dinallo said.

The Senate Agriculture Committee organized the CDS hearing because it has jurisdiction over the Commodity Futures Trading Commission.

Given the large, complex nature of the CDS market, establishing a complete regulatory framework will take time; Dinallo said.

“We urge the industry, federal agencies and Congress to continue working until that essential goal is reached,” Dinallo said.

A credit default swap is a contract that gives one party the right to collect a cash payment from another party if a borrower defaults on a loan.

Back when the economy was healthier and the likelihood that borrowers such as large corporations would default on their bonds seemed low, many financial services companies and speculators accepted large amounts of default risk for relatively low prices, then passed the default risk on to other parties through additional credit default swaps.

Now, default risk has risen, and the CDS market participants are scrambling to find cash to make good on the guarantees they have sold.

In September Dinallo and New York Gov. David Paterson, D, said some credit default swaps appear to be insurance transactions that should be subject to state regulation.

“We will be prepared to consider any necessary changes in state law to prevent problems that might arise from the fact that some swaps are insurance,” Dinallo said at the hearing.

While Dinallo was suggesting that New York state might not jump to supervise the CDS market, other hearing participants were suggesting that Congress should require use of futures exchanges or “central county parties” to make the market more orderly.

Sen. Thomas Harkin, D-Iowa, chairman of the Senate Agriculture Committee, said he was introducing a bill that would shift CDS transactions and other derivative transactions onto a regulated futures exchange, under the jurisdiction of the CFTC.

Moving the CDS market onto a regulated exchange would clear away the current air of “casino capitalism” that now surrounds the market, Harkin said.

“Everyone will know exactly what’s going on,” he said.

With the end of the legislative year quickly approaching, “nothing will be done [on the bill] this year,” Harkin predicted. But “I wanted to get [the bill] out there and sort of test the waters, see what the reaction would be.”

Harkin said he will reintroduce the bill Jan. 6, 2009, when senators return to Washington.

Meanwhile, while Harkin was talking about shifting the CDS market onto a futures exchange, representatives from the CFTC, the Federal Reserve Board and the U.S. Securities and Exchange Commission said the agencies have been working together to evaluate proposals for using “central counter parties” to keep tabs on the CDS market.

The CFTC, the SEC and the Federal Reserve have signed a memorandum of understand that establishes a “framework for ongoing consultation and information-sharing related to CCPs for CDS,” Patrick Parkinson, a Federal Reserve deputy director, testified.

A central counter party would clear and settle CDS contracts, according to Erik Sirri, an SEC director.

“The CCP could substitute itself as the purchaser to the CDS seller and the seller to the CDS buyer,” Sirri said.

If a strong central counter party stood in between the counterparty transferring the default risk and the counterparty accepting the default risk, “the two counterparties to a CDS would no longer be exposed to each others’ credit risk,” Sirri said. “A single, well-managed, regulated CCP could vastly simplify the containment of the failure of a major market participant.”

Harkin said clearing CDS trades through a central counter party or clearinghouse would not provide enough oversight.

“We have to bring all of these swaps and derivatives onto regulated exchanges,” which would entail daily reporting, increased transparency and margin requirements, Harkin said.

Harkin said he is not interested in a jurisdiction fight over the CDS market with the Fed, the CFTC or another regulator.

But Harkin said he believes that credit default swaps should be viewed as futures contracts.

“They are a futures contract, because the basis of it is something that does, or does not, happen in the future,” Harkin said.


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