As It Turns Out, Some CDS Trades May Be Made With Inside Information

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We cannot remember a time when there wasn't concern about possibly widespread insider trading in the credit derivative market. Today, the Wall Street Journal is prompted to cover the story by a statement "12 trade associations for the U.S. and global financial markets" who are promising "to promote fair and competitive markets in which the inappropriate use of material nonpublic information is not tolerated."
Twelve! Must be serious.
But the Journal does a good job of covering the mechanism for how inside information may be leaking out into the markets.

The potential misuse of confidential information is a significant concern as more banks and institutional investors now have access to private information through their participation in the booming market for syndicated loans, which are financed by groups of lenders.
A number of companies and private-equity investors are using syndicated loans to finance major acquisitions or refinance old debt, and typically provide lenders with more information and financial projections than they share with stock and bond investors.
One deal mentioned in the Credit Derivatives Research report was the acquisition of Freescale Semiconductor Inc. by a consortium led by private-equity firm Blackstone Group. In the weeks after Blackstone approached the company about a possible acquisition in May, prices of derivative contracts tied to Freescale's debt climbed more than 25%, according to data from Markit Group. When news of a $17.6 billion buyout deal became public in September, those contracts more than tripled in value.

Since we used to work in the syndicated loan business, we can safely say that it is impossible to underestimate the level of inside information the lead banks on a syndicated loan deal get during the diligence process. We've been on deals where the bankers arranging the deals probably knew more about the company than the chief financial officer. It would be surprising if some of this information didn't occasionally leak out.
What's more, the syndication process involves getting on the phone with a lot of potential lenders to sell the debt and spread around the risk. This is certainly a tip-off that something is happening at the company, and often it's something that will probably increase credit risk.
That said, it's important to emphasize that securities laws do not make all trading on non-public information. The Journal quotes Larry Ribstein on this point.

"There's definitely a lot of trading on nonpublic information, and that's only going to increase with the growing clout of hedge funds," says Larry Ribstein, a law professor at the University of Illinois.
But he notes there is a distinction between that and insider trading on information that is illegally obtained. "There's all kinds of information floating around that could signal merger activity," Prof. Ribstein adds.

Trading Groups Are Agitating Over Apparent Leaks on Street [Wall Street Journal]

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