Does the Dodd-frank Wall Street Reform Act Rein in Credit Default Swaps? an Eu Comparative Analysis

• Publication year: 2021

89 Nebraska L. Rev.587. Does the Dodd-Frank Wall Street Reform Act Rein In Credit Default Swaps? An EU Comparative Analysis

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Robert S. Bloink(fn*)

Does the Dodd-Frank Wall Street Reform Act Rein In Credit Default Swaps? An EU Comparative Analysis

TABLE OF CONTENTS

I. Introduction..........................................588

II. Overview of Credit Default Swaps.....................594
A. Introduction.......................................594
B. Secondary Market for CDSs.......................596
C. Options and CDSs-Leverage to Build or Bury.....597

III. The Role of CDSs in the AIG and Greek Crises ................................598
A. The Greek Debt Crisis and Bailout ................598
B. The Collapse and Bailout of AIG...................600
C. Similarities Between Greece and AIG..............602
IV. U.S. Regulation of CDSs..............................603
A. Introduction.......................................603
B. The Dodd-Frank Wall Street Reform and Consumer Protection Act.....................................605
1. Introduction to the Act ........................605
2. SEC/CFTC Jurisdiction Over "Swaps" Under the Act............................................607
3. Clearing for CDS ..............................608
4. Registration of Swap Dealers and Major Security-Based Swap Participants..............609
5. Restriction on Government Bailouts of Swap Entitities-the "Swap Pushout Rule" ...........610

V. European Proposals for Regulation of CDSs ...........612
VI. The Insurable Interest Requirement...................615
A. Introduction.......................................615

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B.Origin of the Insurable Interest Requirement........................................ 616
C. New York's Attempt to Regulate CDSs as Insurance......................................... 618
D. Insurable Interest Requirement Would Stop Market Manipulation by Speculators in CDSs.............. 619

VII. Naked Short Selling and Uncovered Credit Default Swaps................................................ 620
A. Introduction to Short-Selling and Naked Short Selling ............................................ 621
B. U.S. Regulation of Naked Short Selling............ 623
C. Distinctions Between Naked Short Selling and Uncovered CDSs.................................. 624

VIII. Why the Analogy between Fire Insurance and Uncovered CDSs Fails ................................627
A.Differences Between Hedging and Insurance.......627
B.Distinctions Between Moral Hazards Present in Fire Insurance and Uncovered CDS Positions ...........628
C.CDSs: Information and Price Discovery ............631
D.A Policy Choice ................................... 632

IX. Conclusion ............................................ 633

I. INTRODUCTION

The global economic crisis brought credit default swaps (CDSs) out of the shadows of Wall Street and into the public consciousness.(fn1) As journalists and academics try to make sense of the economic downturn, CDSs figure prominently in their narratives.(fn2) Politicians and regulators have taken aim at these complex and, what are perceived

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as, largely speculative financial plays, believing that this speculation was a major factor contributing to the global economic downturn.(fn3) As a result, uncovered credit default swaps-and naked short selling- are frequently the target of regulators crafting prophylactic regulations designed to prevent future crises.(fn4)

The U.S. has taken the lead on financial reform, including regulation of CDSs. The Dodd-Frank Wall Street Reform and Consumer Protection Act,(fn5) signed into law by President Obama on July 21, 2010,(fn6) includes a nascent framework for comprehensive regulation of credit default swaps.(fn7) This groundbreaking legislation not only significantly changes how CDSs and swaps generally are transacted and regulated, but it also mandates further study of the complex market forces responsible for the global economic downturn that are yet to be fully understood.(fn8) This Article responds to the legislative call and examines if the Dodd-Frank legislation went far enough in regulating CDSs by examining alternative approaches for regulating CDSs being considered by our European counterparts.(fn9)

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As part of the global financial marketplace, credit default swaps- with a global marketplace worth an estimated $60 trillion(fn10)-have undoubtedly played a role in the recent financial crisis.(fn11) For instance, insurance giant AIG figured prominently in the collapse and subsequent government bailout, having written hundreds of billions in CDS protection.(fn12) When the economy took a dive as the sub-prime mortgage debacle kicked off, AIG was increasingly stretched thin as demands on its capital threatened to topple the company.(fn13) In turn, a meltdown at AIG threatened to begin a domino collapse of banks and hedge funds, all dependent on AIG for protection in the event that the economy took a turn for the worse.(fn14) The Federal Reserve (Fed) eventually stepped in, providing a $182 billion bailout(fn15) to keep the insurer afloat and stave off a broader economic collapse.(fn16) The Fed's rescue effort sparked a public outrage,(fn17) which soon turned from the recipient of the bailout to the financial instruments which precipitated its fall.(fn18)

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Interest in the role of CDSs in the financial crisis peaked again in early 2010, when the Greek government faced certain collapse,(fn19) leading to an EU-IMF bailout.(fn20) Perhaps influenced by events in the U.S., the Greek government was quick to blame speculators for its financial woes-particularly speculators purchasing CDSs on Greek sovereign debt.(fn21) In Athens's view, CDSs intensified and hastened events leading to its financial instability and necessitating an EU bailout.(fn22)

Some commentators and industry insiders claim that speculators, and innovative finance in general, are just scapegoats in the regulators' quest to pin the blame for the financial catastrophe on a sector that is little understood and even distrusted by the public at large.(fn23)They say that governments seek to blame speculators at every financial crisis rather than take responsibility for their part in making the crisis.(fn24) Others claim that speculators in derivatives like CDSs are little more than gamblers, contributing nothing to the "real econ-omy."(fn25) These commentators link CDSs with activities-like gam-

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bling-that carry a degree of social stigma,(fn26) and they associate CDSs with fraudulent investment practices like Ponzi schemes.(fn27) Beyond simple name calling, speculators are accused of distorting the underlying market and even of using CDSs to manipulate the market to their profit by taking steps to sink companies and governments.(fn28)

Responding to these losses and public outrage over "Wall Street [e]xcesses,"(fn29) numerous proposals to regulate CDSs have emerged. A theme running through much of this commentary is the analogy between CDSs and insurance policies.(fn30) Like a casualty or life insurance policy, a CDS makes a payout to its purchaser on the occurrence of a loss event.(fn31) In the case of a life insurance policy, the loss event is the death of the insured.(fn32) Under a CDS contract, the loss event- called a "credit event"-is generally a company or government's de-

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fault on its bond obligations.(fn33) Insurance provides an easy analog for credit derivatives like CDSs, and insurance provides ready infrastructure and a regulatory blueprint for CDS regulation.(fn34)

This line of proposals suggests that, like an insurance policy, a CDS should not be issued without the purchaser having an insurable interest in the "property" insured by the policy-i.e. the CDS's reference obligation. Imposition of an insurable interest requirement on CDSs would prohibit an investor from purchasing CDS protection unless the investor also owns an asset on which the CDS is written.(fn35)

The analogy between insurance and CDSs has many proponents because the contracts are similar, in that both types of contracts protect the purchaser from risk, transferring it to another party.(fn36) However, we must examine the contractual difference between a traditional insurance policy and a CDS and the sphere of influence of each type of contract before accepting insurance regulation as a map for regulation of CDSs.

Supplementing the comparison between CDSs and insurance policies, CDSs are often condemned in the same breath as naked short selling,(fn37) which has been the subject of increasingly strict federal (and worldwide) regulation in the past decade.(fn38) Similar to insurance, naked short selling provides a ready analogue to credit derivatives like CDSs. Like the analogy with insurance, the analogy between CDSs and financial transactions such as short selling has a certain intuitive appeal and yields valuable insight into the problems presented by CDSs.

The U.S. legislative effort directed at CDSs has shifted away from an insurance based approach, focusing instead on increasing transparency in the CDS markets.(fn39) Although officials of the European

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Union have yet to finalize comprehensive financial reform, having issued only a limited set of proposed rules on naked short selling and uncovered CDSs at the time this Article went to press,(fn40) the proposed rules have developed under the paradigm of an...