Transparency for Credit Default Swaps

The Securities and Exchange Commission took further action last week to help increase the transparency of credit default swaps by approving conditional exemptions that will allow the Chicago Mercantile Exchange Inc. (CME) to operate as a central counterparty for clearing them. CME joins LCH Clearnet and ICE US Trust in the role of clearing house for credit default swaps, which until recently have been shrouded in mystery.

These moves to create clearing houses provide the SEC with regulatory oversight that should enhance the quality of the credit default swap market and the SEC’s ability to protect investors. Goodbye smoke and mirrors.

In November, then Chairman Cox stressed the need for oversight.

“The virtually-unregulated over-the-counter market in credit default swaps has played a significant role in the credit crisis, including the now $167 billion taxpayer rescue of AIG. Bringing transparency to this market is vitally important. The SEC has regulatory and supervisory authorities over the clearing agencies that may be established for credit default swaps, and we will use those authorities to strengthen the market infrastructure and to protect investors.”

What is a Credit Default Swap?

A credit default swap (CDS) is a contract wherein a buyer makes a series of payments to a seller over time. In exchange, the buyer receives a payoff if a credit instrument (a bond or a loan) goes into default (fails to pay). Depending on the terms, the event that triggers the payoff could also be a restructuring, bankruptcy or downgraded credit rating. The buyer of a CDS is basically betting against the company that owes on the underlying debt.

While credit default swaps have been compared to insurance, there are some important differences:

• The seller doesn’t have to be a regulated entity. (This is what the SEC is working on changing).
• United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract.
• Accounting for CDS is not transparent.
• The buyer of a CDS does not need to own the underlying security or other form of credit exposure. In fact the buyer does not even have to suffer a loss from the default event. By contrast, to purchase insurance the insured is generally expected to have an insurable interest such as owning a debt.

This is the type of smoke and mirror financing that we all need to uncover and understand if we want our economy to work again.