The SEC generally refers to illegal insider trading as “the act of buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.” ((The United States Securities and Exchange Commission, “Insider Trading”, http://www.sec.gov/answers/insider.htm.)) Intuitively, many people feel insider trading is an unfair abuse of information asymmetries that allows one transacting party to take advantage of the other. ((Douglas Levene, “Credit Default Swaps and Insider Trading”, 7 Va. L. & Bus. Rev. 231, 285-86 (2012).)) The level playing field of the market is lost to the advantage of parties with more access to non-public information. ((Id. at 287.)) But can the same rationales used to justify the ban of insider trading in equity markets carry over to derivatives? In this two-part blog post, I will examine the application of the Dodd-Frank Wall Street Reform and Consumer Protection Act to insider trading of derivatives, specifically credit default swaps. In this first post I will introduce credit default swaps and the associated market, the parties that trade them, and provide a historical overview of the relevant regulation. In the second post, I will show how regulation limiting insider trading in the credit default swap market is inefficient and obstructs meaningful information from reaching regulators and securities professionals.
The International Swaps and Derivatives Association (ISDA) defines credit default swap as a “contractual agreement that transfers the default risk of one or more reference entities from one party to the other.” ((How Credit Default Swaps Work, ISDA, http://www.isdacdsmarketplace.com/about_cds_market/how_cds_work.)) The ISDA is a leading trade organization of derivative traders and dealers that helps to standardize derivative contracts and lobbies for industry interests. ((About ISDA, http://www2.isda.org/about-isda/.))The default risk the parties are contracting around is not limited to actual credit default. The parties can in principle agree to the occurrence of any event as the payment trigger. The reference entity is usually a bond. ((Wayne Pinsent, Credit Default Swaps: An Introduction, Investopedia, http://www.investopedia.com/articles/optioninvestor/08/cds.asp.)) This is the security that is underlying the transaction. One party, the protection buyer, pays a periodic fee to the other party, the protection seller, for the duration of the CDS life. ((How Credit Default Swaps Work, ISDA, http://www.isdacdsmarketplace.com/about_cds_market/how_cds_work.)) If the trigger event occurs, the protection seller pays the protection buyer for the loss through a prior agreed upon mechanism. ((Id.)) The par value of the underlying entity the protection buyer seeks to protect is referred to as the notional amount of the reference entity. ((Id.)) In this way CDS can be thought of as auto or home insurance. The home owner pays a periodic fee, and in exchange the insurance company agrees to pay the policy in the event of adverse trigger condition as predefined in the contract. As such, CDS make great hedging tools for parties seeking downside protection on their investment. Alternatively, CDS can be used for speculation, but that is outside the scope of this post. ((See http://www.learningmarkets.com/speculating-with-credit-default-swaps/.))
The SEC regulates insider trading through Rule 10(b)-5 of the Exchange Act. When Congress passed the Commodity Futures and Modernization Act of 2000, they extended Rule 10(b) to cover derivatives, including security based swap agreements. ((Levene, at 263.)) Market participants found the definition unclear as applied to CDS. ((Id.)) It was not until a case in 2010 that courts defined security based swap agreements to include CDS. ((Levene at 264, citing SEC v. Rorech, 720 F. Supp. 2d 367, 405-07 (S.D.N.Y. 2010).)) When Congress Passed the Dodd-Frank Act, they revised the definition of security based swap to include any contract based on the “occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security … provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer”. ((Levene at 264, 265 citing 15 U.S.C. § 78c(a)(68).)) With CDS now clearly within the reach of Rule 10(b)-5, the next question is what is the impact on the market? In the next post I’ll explore some unintended side effects of Dodd-Frank and their ramifications on the larger capital markets.
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