CDS Reform: Making Wall Street Safe for Capitalism

CDS reform is getting closer to becoming a reality: here is a link to the Treasury announcement. In addition to Geithner's version, which links to a draft of proposed legislation and states the intention to eliminate fraud, manipulation and abuse, there is an outline of principles from Barney Frank and Collin Peterson, which proposes the elimination of naked CDS, by forbidding transactions where the non-dealer party is not hedging a risk. Taken together, the two documents show that the Administration and Congress are moving closer to outlawing the conduct which came within inches of destroying the entire financial system. It has been a long wait: far too long. But the battle is not won: it is imperative to push our recalcitrant representatives to do their jobs and undo the harm they perpetrated by the Commodities Futures Modernization Act (CFMA), which completely exempted CDS from regulation and sowed the seeds of the debacle we have endured.

Financial regulatory reform is going to occur. The remaining questions have to do with the political agenda, whether the forces who stand to benefit from the continuation of the status quo will be successful in emasculating the coming legislation in order to maintain loopholes or niches where they can continue to exact spoils and tribute from legitimate investors, those who work, save and invest. The challenge while this plays out is to keep track of the important issues, one of which is naked CDS.

Naked CDS - Here is what Barney has put on the table:

1. Limitation on Speculation

Prohibition on any purchase of credit protection using a CDS contract unless:

• The party owns the referenced security or (one or more) of the securities in an index of securities.
• The party has a bona fide economic interest that will be protected by the contract.
• The party is a bona fide market maker.
• Regulators will have authority to monitor market activity and impose position limit where necessary.

2. Enhanced Oversight of Speculative Positions

Require confidential reporting to the appropriate regulator of all short interest in CDS contracts by:

• OTC derivatives dealers;
• Investment advisers that manage in excess of $100 million;
• Other entities that are deemed “major market participants”.

In order to prevent abuse, the appropriate regulator has authority to:

• Impose position limits on market participants;
• Ban the purchase of credit protection using CDS by any non-dealer that is not hedging a risk.

Moral Hazard - Back in December of 2007 I wrote an article, highlighting the issues that will now be coming before Congress. I sent copies to my elected representatives and to appointed officials whose duties were in any way related to the issues involved:

Buying a credit default swap on a security backed by sub-prime is insurance, a very good idea if you actually own the security.

But I would submit that these mechanisms create moral hazard when used for speculative purposes. A determined group of negativists can short a company's stock, go long credit default swaps on the same company, and create the appearance of a disaster in progress, meanwhile lining their own pockets at the expense of legitimate investors. Speculation in energy futures at times harms ordinary citizens who must buy energy.

... Perhaps speculators will succeed in destroying the economy - in effect, burning down the house we all live in. That is the true moral hazard.

I now regret the use of the word “speculators”: speculation is a legitimate economic activity, necessary as a source of capital to take the other side of hedges. I should have said “manipulators.” But the point about moral hazard still stands, more clearly following the destructive financial inferno which immolated vast tracts of Wall Street and Main Street, not to mention countless 401ks. We must rid our financial system of this moral hazard.

Undoing CFMA – this was one of the most insidious and destructive pieces of legislation ever churned out by the sausage machine in Washington. Inflated by the gaseous effusions of politics as usual, this pork sausage floated out in late 1999, supported by Larry Summers, completely exempting CDS from regulation and opening the door of opportunity for Enron. Enron, you may recall, created a giant bubble in electrical costs, gouging the citizens of California mercilessly, before imploding from its own fraudulent accounting practices. The bill was never debated in either house and got Bill Clinton's signature just before Christmas, in time for everybody to go home for the holidays.

The worst thing this bill did was to carefully and specifically exempt the innovative miracle, CDS, from any regulation of any kind whatsoever.

The draft legislation comes to 115 pages. I read it, not too carefully. But what I saw was a careful job of undoing the harm perpetrated by CFMA, bringing CDS under regulation and making them subject to the Securities and Exchange Act of 1934. That piece of legislation was developed with the wisdom acquired by the very hard experience of a Depression brought on by the wretched excess on Wall Street. It was and is an excellent piece of legislation and if properly enforced by the SEC it will prevent further recurrences of what we have just experienced – a deep recession caused by more wretched excess by financial manipulators.

Politics of Power and Turf – Geithner's version leaves much of the regulatory power where it is and requires the SEC and CFTC to co-ordinate on CDS. The issues are complex and having more agencies to deal with may result in some loss of focus. Certainly the politics of getting the legislation through will involve a lot of debate over who gets what turf, etc.

Making it safe for Capitalism - In reality what is important is that we the people force our elected representatives to stop dickering and deal-making long enough to create an environment where regulators have both the power and the will to make Wall Street safe for those who work, save and invest.

Comments

[Ricard:]

Great, great article.

"...there is an outline of principles from Barney Frank and Collin Peterson, which proposes the elimination of naked CDS, by forbidding transactions where the non-dealer party is not hedging a risk."

"Buying a credit default swap on a security backed by sub-prime is insurance, a very good idea if you actually own the security."

"But I would submit that these mechanisms create moral hazard when used for speculative purposes."

I cannot emphasize the respect and admiration I have for the author by cutting straight to the chase on what by any standard looks like ethics born from hell.

Aug 12 02:37 PM

[cds ftw:]

Old man doesn't know what he is talking about.

Why are cds worse than puts?

Why is speculation ok, but naked cds's are not?

Why is the possibility that someone *might* manipulate the market reason for banning it altogether?

Aug 12 03:40 PM

[Tom Armistead:]

young man is morally clueless.

you will understand when you grow up, if you do.


On Aug 12 03:40 PM cds ftw wrote:

> Old man doesn't know what he is talking about.
>
> Why are cds worse than puts?
>
> Why is speculation ok, but naked cds's are not?
>
> Why is the possibility that someone *might* manipulate the market
> reason for banning it altogether?

Aug 12 04:05 PM

[TinyTim:]

"regulators have both the power and the will to make Wall Street safe"

Not worried about the power, it's the will from a captive regulator.

Also, the intelligence to recognize risk.

Aug 12 04:13 PM

[Ricard:]

Think about it this way:

I buy a life insurance policy where you are the one being insured. I have no idea who you are...but I know exactly how much I will get when you die. It costs me money to hold this policy over time, so the sooner you die, the sooner I collect on the insurance, and the less I need to pay in premiums. Now, swap me for the CDS holder, you for the underlying bond, and Wall Street as the insurance company.

I already think life insurance has some big negatives going for it, but to be able to buy policies where total strangers are being insured does not sound like a recipe for success.

On Aug 12 03:40 PM cds ftw wrote:

> Old man doesn't know what he is talking about.
>
> Why are cds worse than puts?
>
> Why is speculation ok, but naked cds's are not?
>
> Why is the possibility that someone *might* manipulate the market
> reason for banning it altogether?

Aug 12 07:09 PM

[Tom Armistead:]

Thanks Ricard, that's the example I would have have given myself.

Tom

Aug 12 10:09 PM

[cds ftw:]

Thanks for addressing the points above guys! Especially regarding put options!

Aug 13 03:02 AM

[cds ftw:]

WB is not a derivatives guy, so why would he be better placed to understand them than people who work in the industry?

And are you *really* saying that uncolalteralised derivs are better than collateralised?!


On Aug 13 04:05 AM dividendmachine1 wrote:

> enjoyed this
>
> Most investors would be best served to only make investments in such
> where they TOTALLY understand what they are doing
>
> Even Buffett says he does not understand 90% of the cdos
>
> If he doesnt NO one does
>
> The ones he does own 1) he wrote himself and 2) he gets the money
> upfront and has NO counter party risk

Aug 13 06:49 AM

[pone:]

On Aug 12 03:40 PM cds ftw wrote:
> Why are cds worse than puts?
>
> Why is speculation ok, but naked cds's are not?

Put and call buying exaggerate demand and supply for the stock, but this tends to be self-regulating excess because ultimately the value of the stock will reflect the continued financial results of the company, and the stock market is very liquid.

CDS speculation is far more dangerous because the CDS insurance rate is supposed to be an insurer's direct reflection on the chances that a company will go bankrupt. If a short seller buys enormous numbers of CDS contracts and pushes up the rate to some speculative meaningless value, it incorrectly suggests the company is in some immediate peril, which then forces a sell off of both bonds and stocks in the company. Because CDS is NOT a liquid market (it was in fact *designed* to be illiquid in order for Wall Street to gouge huge fees at every step) it is possible to completely distort CDS pricing for an extended period of time, independent of the financial performance of the underlying company.

We shouldn't want an illiquid market to be unregulated when it can be used to incorrectly price the risk of bankruptcy in an entity.


> Why is the possibility that someone *might* manipulate the market
> reason for banning it altogether?

Because they *did* manipulate the market, and it almost collapsed the entire financial industry.

Aug 14 02:30 AM

[pone:]

Maybe we do not have a third world financial system in this country, but I am starting to wonder if we do not have a second world financial system. Consider how antique many of our trading and settlement systems are.

For stocks, do people realize that for 99% of all trades on the US market, the buyer of the stock never takes ownership in his name? The stock is left in the name of the broker (the "street name") and you are trusting the broker's internal systems to correct assign the stock to you. If the broker goes bankrupt, you have potential risk to lose the asset, particularly for amounts in excess of insured coverage. The only way to register a stock in your name is to take physical possession of the stock certificate, then go through a complex and time consuming registration process. Obviously no one has time for that.

Compare our stock market to Australia and other systems where the ownership of the equity is traded electronically, and even if your broker goes belly up you remain the registered owner of the security, and all of the key registration data is transferred instantly when you buy or sell the security.

Look at our bond market, which is a shocking and almost fraudulently anti-competitive market. Do people understand that every time a small investor buys or sells a bond that Wall Street has rigged this system so that you lose three to six percent of your principal on every trade? Go compare the bond quote your broker gives you to the trades recorded on FINRA. It's shocking.

In our bond market there is no single electronic exchange for trading. You cannot efficiently register a limit price for buying or selling as an investor. You cannot transparently examine the trade, and the markups at multiple levels of middlemen. Try to even publish the bond trade data, and you find that Wall Street has managed to "self-regulate" the trade data in such a way that you have to pay them millions of dollars for the data and cannot then publish it for others to examine.

CDS is simply the ultimate excess in corrupt Wall Street attempts to "self-regulate" a financial market in a way that deliberately limits competition, limits price discovery, and maximizes Wall Street fees. But it's hardly unique.

While the attempt to regulate CDS is welcome, it seems to me our inability to bring our stock and bond markets to a First World standard of transparency and competitiveness is a huge stain on our country and its financial market credibility. With so much of our government financial regulatory infrastructure captured by the entities we are regulating, government has become the advocate of the financial middleman and stopped being the advocate for the consumer.

Aug 14 02:47 AM

[Tom Armistead:]

These are all good points. DTCC has a CNS system that permits manipulators to trade fictitious shares for days at a time, another example, while the technology is easily developed to individually identify every share electronically and limit short sellers to selling specifically identified shares that they have actually borrowed.

Options I am required to bid and ask in nickels and dimes, but somethimes my fills come through improved by pennies, I guess my brokers have the privilege to give me the pennies or shave them off the top. There is no reason to quote in nickels other than to keep spreads wide for the benefit of market makers.

And so it goes. I just finished getting letters off to my congressmen on the CDS, I guess it's time to start writing them on the other issues also.


On Aug 14 02:47 AM pone wrote:

> Maybe we do not have a third world financial system in this country,
> but I am starting to wonder if we do not have a second world financial
> system. Consider how antique many of our trading and settlement systems
> are.
>
> For stocks, do people realize that for 99% of all trades on the US
> market, the buyer of the stock never takes ownership in his name?
> The stock is left in the name of the broker (the "street name") and
> you are trusting the broker's internal systems to correct assign
> the stock to you. If the broker goes bankrupt, you have potential
> risk to lose the asset, particularly for amounts in excess of insured
> coverage. The only way to register a stock in your name is to take
> physical possession of the stock certificate, then go through a complex
> and time consuming registration process. Obviously no one has time
> for that.
>
> Compare our stock market to Australia and other systems where the
> ownership of the equity is traded electronically, and even if your
> broker goes belly up you remain the registered owner of the security,
> and all of the key registration data is transferred instantly when
> you buy or sell the security.
>
> Look at our bond market, which is a shocking and almost fraudulently
> anti-competitive market. Do people understand that every time a small
> investor buys or sells a bond that Wall Street has rigged this system
> so that you lose three to six percent of your principal on every
> trade? Go compare the bond quote your broker gives you to the trades
> recorded on FINRA. It's shocking.
>
> In our bond market there is no single electronic exchange for trading.
> You cannot efficiently register a limit price for buying or selling
> as an investor. You cannot transparently examine the trade, and the
> markups at multiple levels of middlemen. Try to even publish the
> bond trade data, and you find that Wall Street has managed to "self-regulate"
> the trade data in such a way that you have to pay them millions of
> dollars for the data and cannot then publish it for others to examine.
>
>
> CDS is simply the ultimate excess in corrupt Wall Street attempts
> to "self-regulate" a financial market in a way that deliberately
> limits competition, limits price discovery, and maximizes Wall Street
> fees. But it's hardly unique.
>
> While the attempt to regulate CDS is welcome, it seems to me our
> inability to bring our stock and bond markets to a First World standard
> of transparency and competitiveness is a huge stain on our country
> and its financial market credibility. With so much of our government
> financial regulatory infrastructure captured by the entities we are
> regulating, government has become the advocate of the financial middleman
> and stopped being the advocate for the consumer.

Aug 14 09:57 AM

[Michael Clark:]

Thanks for posting, Tom.

Aug 14 11:07 AM

[pone:]

On Aug 14 09:57 AM Tom Armistead wrote:
> And so it goes. I just finished getting letters off to my congressmen
> on the CDS, I guess it's time to start writing them on the other
> issues also.

For me the worst situation is the corporate and government bond market. This market is many times the size of the stock market, yet it trades through a loose collection of broker dealers and without an electronic exchange and full transparency. How people can allow a situation where the middleman is taking 3%+ on every trade in a multi-trillion dollar marketplace is incomprehensible.

Aug 15 01:18 AM

[pone:]

On Aug 14 09:57 AM Tom Armistead wrote:
> These are all good points. DTCC has a CNS system that permits manipulators
> to trade fictitious shares for days at a time, another example, while
> the technology is easily developed to individually identify every
> share electronically and limit short sellers to selling specifically
> identified shares that they have actually borrowed.

Tom, do you know of a good resource that explains the patchwork of financial regulatory structures in the US for various financial markets? When I visit the DTCC's web site it is barely comprehensible to me, and some of these sites like FINRA seem to be industry-controlled, whereas others pretend to be pseudo-governmental bodies that are in fact just captured regulators that do whatever the 20 largest banks tell them to do.

Aug 15 01:23 AM

[biomedlives:]

"Look at our bond market, which is a shocking and almost fraudulently anti-competitive market. Do people understand that every time a small investor buys or sells a bond that Wall Street has rigged this system so that you lose three to six percent of your principal on every trade? Go compare the bond quote your broker gives you to the trades recorded on FINRA. It's shocking."

For this reason, I never buy individual corporate bonds.


On Aug 14 02:47 AM pone wrote:

> Maybe we do not have a third world financial system in this country,
> but I am starting to wonder if we do not have a second world financial
> system. Consider how antique many of our trading and settlement
> systems are.
>
> For stocks, do people realize that for 99% of all trades on the US
> market, the buyer of the stock never takes ownership in his name?
> The stock is left in the name of the broker (the "street name") and
> you are trusting the broker's internal systems to correct assign
> the stock to you. If the broker goes bankrupt, you have potential
> risk to lose the asset, particularly for amounts in excess of insured
> coverage. The only way to register a stock in your name is to take
> physical possession of the stock certificate, then go through a complex
> and time consuming registration process. Obviously no one has time
> for that.
>
> Compare our stock market to Australia and other systems where the
> ownership of the equity is traded electronically, and even if your
> broker goes belly up you remain the registered owner of the security,
> and all of the key registration data is transferred instantly when
> you buy or sell the security.
>
> Look at our bond market, which is a shocking and almost fraudulently
> anti-competitive market. Do people understand that every time a
> small investor buys or sells a bond that Wall Street has rigged this
> system so that you lose three to six percent of your principal on
> every trade? Go compare the bond quote your broker gives you to
> the trades recorded on FINRA. It's shocking.
>
> In our bond market there is no single electronic exchange for trading.
> You cannot efficiently register a limit price for buying or selling
> as an investor. You cannot transparently examine the trade, and
> the markups at multiple levels of middlemen. Try to even publish
> the bond trade data, and you find that Wall Street has managed to
> "self-regulate" the trade data in such a way that you have to pay
> them millions of dollars for the data and cannot then publish it
> for others to examine.
>
> CDS is simply the ultimate excess in corrupt Wall Street attempts
> to "self-regulate" a financial market in a way that deliberately
> limits competition, limits price discovery, and maximizes Wall Street
> fees. But it's hardly unique.
>
> While the attempt to regulate CDS is welcome, it seems to me our
> inability to bring our stock and bond markets to a First World standard
> of transparency and competitiveness is a huge stain on our country
> and its financial market credibility. With so much of our government
> financial regulatory infrastructure captured by the entities we are
> regulating, government has become the advocate of the financial middleman
> and stopped being the advocate for the consumer.

Aug 31 09:59 AM