Lawbitrage

Hedge Funds Transfer Credit Risk to Derivatives Dealers

A report released today by the Bank for International Settlements (BIS) provides some of the most detailed information to date about how credit default swaps (CDS) transfer credit risk between different institutions.

The BIS report shows that CDS dealers on net bought protection from all other types of counterparties except for hedge funds. When it comes to hedge funds, CDS dealers are not only net protection sellers, but from June 2010 to June 2011 hedge funds about doubled their protection buying from dealers to over $300 billion. This is shown by two panels from Graph 1 of the report, which is entitled "Net credit protection bought by reporting dealers from different counterparty groups":

Accordingly, in the past year or so hedge funds have been using CDSs to express increasingly bearish views on debt markets, which the report indicates primarily relate to sovereign and (non-financial) corporate debt. And because these graphs show that dealers are net long in their CDS positions, hedge funds' CDS shorts are probably ultimately being absorbed by the other categories of counterparties.

My own working paper on the broader topic of credit risk transfer governance is available here.

Doesn't Anyone Want to Be a Swap Anymore?

Prior to the financial crisis, the relatively light regulation of credit default swaps (CDSs) led some market participants to seek to use CDSs as an alternative to regulated transactions. For example, insurance companies received regulatory approval to have certain CDSs not be treated as regulated insurance products. As I noted,

From 1997 to 2000, the New York State Insurance Department issued a series of statements holding that CDSs do not qualify as insurance contracts under New York law and in 2004 codified that position in Article 69 of the New York Insurance Law. A CDS was held not to be insurance because “the payment by the protection buyer is not conditioned upon an actual pecuniary loss.” This position permitted regulated financial guaranty insurance companies (also known as monoline bond insurers) to guaranty CDSs written on mortgage-related securities by their unregulated affiliates.

But due to the more recent efforts to regulate swaps under the Dodd-Frank Act, including rules that will likely impose costly capital and margin requirements for uncleared swaps, insurers are now strongly resistant to having any of their products fall under the definition of "swap."

And they are making that position known to regulators.

In response to regulators' proposed (and yet-to-be-finalized) rules from earlier this year that excluded insurance agreements from the definition of swap, comments from groups such as the Association of Financial Guaranty Insurers seek to broaden and make-certain the insurance product exclusion. They are seeking to do this by requesting that regulators don't finalize what they perceive to be unnecessary criteria for what qualifies as insurance:

The addition of further qualifications that must be met before an insurance policy or contract is exempted from the definition of the term swap creates legal uncertainty....For example, the requirement that a beneficiary of an insurance policy carry the risk of loss continuously throughout the duration of such insurance policy [in order for the policy not to be a "swap"] creates legal uncertainty when applied to a freely tradable insured bond.

Other commentators have expressed similar worries that other transactions may be treated as swaps for regulatory purposes. How times have changed.

Markets Hardly Rely on Credit Ratings

...according to the sources in this International Financing Review story by Drazen Jorgic:

“I think the fixed income market is 90% driven by people who have their own research,” said Peter Harvey, fund manager and head of credit for Cazenove Capital. ”Big firms like Pimco or BlackRock, and even Cazenove, have their own proprietary research and their own ratings and analysts, therefore they don’t really look at rating agencies.”

For the other 10%, Harvey said, credit rating agencies do a good job. ”Small private banks and ’mom & pop’ investors clearly don’t have 25 investment analysts working for them and the agencies are central to them.”

But if central agencies act as a genuine guide for only 10% of the market, or serve the “mom & pop” investors, clearly their influence could be on the wane.

“Big market players look at the [credit default swap] market and not the rating agencies,” said one chief investment officer.

If most investors don't take credit ratings all that seriously, and already rely on CDS spreads to assess creditworthiness, then regulators may not face insurmountable challenges in their ongoing efforts to decrease dependence on ratings.

Lawbitrage Links (10/27/11)

"[I]t does not appear to be likely that the [proposed Greek] restructuring will trigger payments under existing CDS contracts" (ISDA Q&A, updated 10/27/11).

A short history and definitions of the restructuring CDS credit event (Markit, pages 23-25).

"[S]tates with larger budgets examine more banks independently" rather than with federal examiners (Marcelo Rezende).

Risk management lessons from Margin Call (Dave Ingram and Max Rudolph).

FDIC's discretion in determining the payment priority of failed bank creditors (Reed Smith).

A bill that would increase the maximum number of shareholders permitted for private companies to 1000 from 500 obtains committee approval (CCH).

...which is something I argued for in 2008 in the context of hedge funds for retail investors (Fending for Themselves).

Concerns About Regulatory Arbitrage May Be Overstated

Last week, four U.S. Senators sent a letter to the heads of the major financial regulators expressing concern about extending U.S. swaps regulation outside of the U.S. A primary focus of the letter was preventing duplicative or inconsistent regulation from harming U.S. competitiveness. However, the Senators also expressed concern with potential harm from regulatory arbitrage that arises from inconsistent regulation across national jurisdictions. 

Regulatory arbitrage acheived by conducting transactions outside of the U.S. may not be a significant problem, however. The primary type of arbitrage underlying the financial crisis was not about avoiding regulation per se, and certainly not by transacting outside of the U.S. Rather, the arbitrage that did occur was more indirect; it took advantage of domestic regulations that failed to account for the true risk of certain transactions.

In particular, certain transactions took advantage of the fact that risk-based bank capital regulation gave too much relief, but the amount of relief given was by design. When banks sold assets to conduits and provided liquidity guarantees, or held onto AAA-rated mortgage-related securities to benefit from their relatively low capital charges, they were not so much avoiding regulation as complying with regulations that made risky transactions more profitable. In the case of AIG, the company was brought down by the swaps it sold for parties to hedge risk, not its larger portfolio of swaps that gave European banks regulatory capital relief. (See footnote 94 and accompanying text from the June 2010 Congressional Oversight Panel report).

Regulators should thus be mindful that the biggest danger to the regulatory regime now emerging is probably not that market participants will transact around it abroad, but rather that too many participants will actually comply with it in a way that ultimately increases risk. Newly moving swaps to central counterparties (CCPs) may be just such a development, as parties are now "placing a lot of reliance on regulators to get these standards right and ensure CCPs are really robust."