Nothing like a turf war to wake up a sleepy regulator. It seems rather telling that Cox has developed a sudden interest in the credit default swaps market a mere day after New York State announced that it will regulate the product (to the limited extent it can) starting January of next year. (Although the SEC apparently prepared its remarks last week, the New York initiative did not spring into being overnight and the SEC was no doubt notified in advance as a courtesy).
I’d feel a bit happier if these CDS-regulator-wannabes had a clearer idea of what they wanted to do with the authority they are seeking.
U.S. Securities and Exchange Commission Chairman Christopher Cox said Congress should “immediately” grant authority to regulate credit-default swaps amid concern the bets are fueling the global financial crisis.
“Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure,” Cox told the Senate Banking Committee today at a hearing on the government’s $700 billion financial rescue plan. Lawmakers should provide the authority “to enhance investor protection and ensure the operation of fair and orderly markets,” he said….
The SEC is concerned investors may seek to profit by spreading false information or making trades designed to drive down financial stocks during the credit crisis that has re- shaped Wall Street. The agency is demanding hedge-fund managers, brokerages and institutional investors describe in sworn statements their bets on the companies, including trades in credit-default swaps, the regulator said Sept. 19.
So at least as presented at Bloomberg, the SEC’s concern isn’t the bugaboo that has caused the most worry, that CDS have the potential to crash the financial system via cascading counterparty defaults. No, it’s that they are an alternative way for evil shorts to attack (supposedly) otherwise sound companies. Indeed, Cox zeroed in on the parallels to stock shorting in his testimony:
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.
Mind you, we are not saying that this is not a legitimate concern; indeed, we’ve posted that games-playing in CDS is a far bigger risk to companies than naked shorting, due to the opaqueness of the CDS market. But by seeing the risks of CDS so narrowly, the SEC (in our book) has disqualified itself as the proper regulator for them.