The recent rescue of American International Group has sparked regulatory action in the State of New York in the hitherto unregulated “covered” credit default swap (CDS) market and could result in new regulation of the “naked” CDS market.
Credit Default Swaps
A CDS is a private contract that transfers credit or default risk related to an underlying or reference entity or obligation from one counterparty (protection buyer) to another (protection seller) in exchange for a payment or stream of payments. There are many variations on this theme that can make the transaction quite complex. In the “plain vanilla” version, the underlying or reference obligation may be a bond issued by a municipality or corporate borrower and held by the protection buyer (a “covered” CDS). The reference obligation may be an asset-backed security (ABS) issued by a conduit that owns a pool of assets (car loans, credit cards) or pools of tranches of assetbacked securities (collateralized debt obligation or CDOs). The entity or obligation may not be a single entity or obligation, but rather a basket of names, whether created for the specific transaction, (i.e., “bespoke”) or based on a publicly traded index. The event requiring the protection seller to make a settlement is usually the bankruptcy of the reference entity or a default in the payment of principal or interest on the reference entity’s obligations in excess of a threshold amount.
However, the CDS may go further and require payment or the posting of collateral — for example, in the event of a ratings decline of the issuer of the reference obligation or of the protection seller. In certain instances, special purpose vehicles (dubbed transformers) may sell a CDS to a counterparty with the transformer’s obligations being guaranteed by a credit-worthy affiliate of the seller, such as a financial guarantee insurer (monolines).
Monolines have historically provided only credit protection or enhancement of the plain vanilla kind by wrapping bonds issued by municipalities or corporate issuers. For the past several years, however, monolines have participated heavily in selling protection in respect of ABSs based on pools of sub-prime mortgages or CDOs based on tranches of such ABSs.
Regulation of CDSs may be based on their characterization as either “insurance” or “securities.” It may also arise from initiatives to move trading to a clearing-house structure with a central counterparty.
Regulation may have significant implications for the operation of the securitization market. It may also affect who may sell protection, the terms of the protection and its cost.
Action by State of New York
In May 2008, New York insurance regulators raised the prospect of regulating the “covered” CDS market under the State’s jurisdiction over insurance products. Apparently, recent events have galvanized the State’s regulators to act.
Adopting the “insurance” approach, the State of New York announced on September 22, 2008 that as of January 1, 2009, the State will regulate the “covered” CDS part of the CDS market that has previously been unregulated. In its Circular Letter No. 19 (2008), the State of New York Insurance Department explained this policy change by characterizing a “covered” CDS as an insurance contract, the seller of which would need to be licensed as an insurer. The department also proposed a number of “best practices” for monolines, which include:
- restricting the insurance of CDOs of ABOs;
- redefining concentration risk;
- restricting the commercial terms of CDSs that monolines may insure;
- imposing oversight of underwriting and risk management standards;
- increasing capital and surplus requirements; and
- increasing reporting.
The State also called on the federal government to regulate the rest of the CDS market.
US Federal Action
The Chairman of the Securities and Exchange Commission (SEC) has requested that authority be granted to the SEC to regulate the CDS market. The US Federal Reserve is encouraging the creation of a clearing-house to act as a counterparty on each trade, eliminating the risk of one side defaulting. The New York Federal Reserve hopes that one or more central counterparties will be operating by the end of 2008. To facilitate and expedite the creation of such central counterparties, the SEC has proposed that such central counterparties will be eligible for exemption from registration requirements if they meet certain conditions. These include giving the SEC access to conduct on-site inspections of all facilities and systems and the books and records of the central counterparty.
How might the “insurance” and “securities” approaches to regulation of CDSs play out in Canada?
Constitutionally, insurance regulation is a shared jurisdiction between the federal government and the provinces. As a matter of property and civil rights, the provinces have the exclusive jurisdiction to regulate market conduct with respect to the sale of insurance, including the types of insurance that may be sold, who may sell insurance and the terms of insurance contracts. Although there is no enumerated head of federal jurisdiction under the constitution in respect of insurance, judicial decisions have accorded power to the federal government to regulate the incorporation, licensing, capital governance and solvency of federal insurance companies, and the licensing and solvency of foreign insurance companies. In the Province of Ontario, the term “insurance” is broadly defined to mean the undertaking by one person to (i) indemnify another person against loss or liability for loss in respect of certain risk or peril to which the object of the insurance may be exposed, or (ii) to pay a sum of money or other thing of value upon the happening of a certain event, and includes life insurance. This definition diverges from the State of New York definition of an insurance contract. In New York, it means any agreement or other transaction whereby one party, the “insurer,” is obligated to confer benefit of pecuniary value upon another party, the “insured” or “beneficiary,” dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest that will be adversely affected by the happening of such event. The broad wording of the Ontario definition has been read down in case law.
Whether a CDS would constitute “insurance” in Ontario would turn on the characterization of the specific terms and conditions of the CDS relative to the statutory definition as interpreted by case law.
Securities regulation is currently a matter of provincial jurisdiction in Canada. Generally speaking, the securities legislation of all provinces and territories regulates trading in securities by requiring those who trade securities to become registered as a dealer. The legislation also requires those who distribute securities to file a prospectus with, and obtain a receipt from, the applicable securities regulatory authorities, in the absence of a statutory exemption or the grant of an exemption order.
Whether the parties to a CDS must comply with the dealer registration and prospectus requirements of Canadian securities legislation is dependent upon the extent to which the CDS can be characterized as a security. The term “security” is broadly defined in Canadian securities legislation and can vary from province to province. In some provinces, the definition expressly contemplates over-the-counter (OTC) derivative transactions, and in others it does not. In either case, the definition is capable of being applied to a wide variety of instruments, particularly if it is applied literally. Canadian market participants have therefore had to contend with a considerable amount of regulatory uncertainty when developing, offering and trading new financial products and services.
For several years, the Ontario Securities Commission sought to establish a rule that would provide a clearly defined regulatory framework for the conduct of OTC derivatives transactions in Ontario. Proposed OSC Rule 91-504 Over-the-Counter Derivatives, which remains under consideration, was intended to regulate the trading of OTC derivatives in Ontario by applying the dealer registration and prospectus requirements of the Securities Act (Ontario) to all transactions involving an OTC derivative, whether it could be characterized as a security or not. Certain transactions could then be exempted from these requirements, including OTC derivative transactions entered into between specified institutional investors and high-net-worth individuals. Rules have been adopted by the British Columbia Securities Commission and the Alberta Securities Commission. As described in the article below, in June 2008, the Québec National Assembly passed the Derivatives Act (Québec), which, upon becoming effective, will establish a comprehensive scheme for the regulation of OTC derivatives transactions in Québec.
None of these Canadian provincial rules or legislation is as specifically directed to the regulation of CDSs as is the proposed New York regulation.
For a more detailed discussion, please see the e-Alert on our website.