Another Knee-Jerk Proposal From Christopher Cox

I’m getting rather annoyed at Christopher Cox. His short-selling ban was a bad idea, but at least it got us through the weekend to a point at which a bailout plan could start taking shape. His work here is done; he should now get out of the way. But no, he’s decided to use his testimony today to rail against the CDS market, of all things.

There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit default swaps — double the amount outstanding in 2006 — is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market. This is an area that our Enforcement Division is focused on using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer outsized incentives to market participants to see an issuer referenced in a CDS default or experience another credit event.

Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can "naked short" the debt of companies without restriction. This potential for unfettered naked shorting and the lack of regulation in this market are cause for great concern. As the Congress considers fundamental reform of the financial system, I urge you to provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets.

Quite aside from the unsavory power-grab aspects of all this, it’s pretty much impossible to think of a worse time for Cox to be calling for such regulatory legislation. We’re in the middle of putting together a $700 billion bailout package here — the last thing we need is the distraction of a debate about derivatives regulation which has been going on at a pretty high level for some years now.

And equating CDS buyers with the demon naked shorters — that’s just irresponsible.

The problem with naked shorting (as opposed to shorting more generally) is that it carries no up-front cost. You don’t need to find a borrow, you don’t need to pay a repo rate, and the only way you can lose money is if the stock price moves against you.

Oh, and it’s illegal.

In the CDS market, the fact that you don’t need to own the underlying security is a feature, not a bug. And when you want to buy protection on a distressed company, boy do you pay for the privilege — not just in bi-annual insurance payments, but also in cash up front. Shorting credit using CDS is much more expensive than shorting any but the most hard-to-borrow stocks — and the worse the credit becomes, the more expensive shorting it gets.

In other words, if you want to drive a stock down using short-selling tactics, that’s much easier and cheaper than trying to drive up credit spreads by buying protection in the CDS market.

And remember too that the CDS market, like any derivatives market, is a zero-sum game. Cox complains of the "significant opportunities that exist for manipulation in the $58 trillion CDS market, which is completely lacking in transparency and completely unregulated" — but it’s very hard to see how buyers of credit protection have manipulated the sellers of credit protection, especially since in the vast majority of cases they’re the same people.

The exception, of course, is the insurance companies. Selling protection is selling insurance, and so the monolines and AIG moved into the business in a very big way. They weren’t hedged: they sold a lot of protection and bought almost none. And they lost a lot of money, on a mark-to-market basis, as a result.

But they’re out of the market now: insurance companies are no longer big sellers of protection, and if you want to buy it you’re going to have to go to someone who’s marking their positions to market daily and dynamically hedging on an intraday basis. And frankly I don’t see a lot of scope for market manipulation there. In any case, insofar as the unregulated nature of the CDS market is a problem — and it is — it’s a problem which is being looked at quite deliberately and carefully by people who really know the market intimately, like Isda and the New York Fed.

The solution, probably, is to try to move the CDS market onto some kind of derivatives exchange, and then have it regulated by the CFTC or its successor. The last thing we need is the SEC blundering in as though it just discovered what was going on here, and writing hurried legislation with all manner of nasty unintended consequences.

After all, the biggest risk of the CDS market is counterparty and settlement risk — not the risk that CDS spreads will be manipulated by evil hedge funds. A lot of that risk has gone away now that AIG and the monolines are no longer taking on asymmetrical CDS exposure, but a lot still remains, and it’s a good idea to regulate it sensibly.

But Cox’s rantings today are a move away from that goal, not a move towards it.