Credit Default Swaps: The Land of Efficient Insider Trading?

Author:
Updated:
Original:

Is the market for credit default swaps rife with insider trading? That depends on what you mean by insider trading.
Use the term in a loose sense—say defining “insider trading” as trades where one party has material nonpublic information unavailable to their trading counterparts—and the answer is clearly yes. There is a lot of that sort of insider trading in the credit default market, and there is likely to be even more as the market grows and more players gather around the table.
But since federal securities regulations against insider trading apply only to insider trading in securities, the question of whether this counts as "insider trading" in a strictly legal sense is murkier. Credit default swaps do not fit the traditional definition of securities. Prior to the enactment of the Commodity Futures Modernization Act of 2000, there was a lot of debate over the legal answer to the question of whether they should be categorized with the most common types of securities-stocks and bonds. The CFMA split the difference by declaring that swaps were not securities but that insider trading and other federal anti-fraud measures still applied to swaps where the underlying credit was a security, such as those based on publicly traded bonds.
But this has been controversial from the start. Few of those trading in the credit default swap market were calling out for protection from insider trading. Many hedge funds and other debt-holders active in the credit default market lack the kind of internal controls and so-called “Chinese Walls” that investment banks and brokerages have had to build to prevent insider trading in securities. And most of the other market participants are aware that this is the situation. In short, there is plenty of asymmetrical information in the credit default swap market but that fact is widely--even symmetrically--known. Moreover, the legal status of more complex financial products not directly tied to individual securities remains murky.
Regardless, it seems the regulators are exactly crying out to enforce insider-trading laws against the traders in the credit default market either. Right now no US regulatory agency claims oversight jurisdiction for credit-default swaps. Not the SEC. Not the Commodity Futures Trading Commission. Not the Treasury Department. Not the Federal Reserve.
Since no one enforces insider trading laws in the credit default swap market, and apparently no one has the jurisdiction to enforce insider trading laws, it seems the laws only apply to the market in some metaphysical, theoretical sense. There's something of a tree falling in an empty forest thing going on with the application of insider trading laws to credit default swaps. If a statute applies insider trading regs to credit default swaps but no one enforces it, does the tree make any sound?
Over on his new blog at Portfolio, Felix Salmon points us toward the remarks of Erik Sirri, the director of the SEC's division of market regulation.
Salmon writes:

Sirri came out and said what everybody in the markets knows but nobody wants to admit: "In a world of important pricing efficiency, you want insiders trading because the price will be more efficient. That is as it should be."
Sirri then went on to explain that insider-trading laws should still exist, for the purpose of investor protection. But he added that he thought it "very important" that credit default swaps be traded – something which won't happen if the tradable contracts fall under insider-trading regulations while the present bilateral contracts don't.

Sirri’s rationale here seems relatively simple. Insider trading laws have efficiency costs but the government has made the decision that in the case of markets for securities those costs are outweighed by the gains in investor protection and investor confidence. Part of the reason for deciding things in this way is because the government, corporate America and the large brokerages want ordinary investors to feel confident they are playing on something of a level playing field with those with potentially better access to information. But in trades involving more sophisticated players trading more sophisticated financial products, it’s far from clear that this rationale applies. Do we really need to protect hedge funds from other hedge funds and investment banks in credit default swap trading? The enforcement and compliance costs with insider trading rules may outweigh the benefits.
Nonetheless, it is entertaining watching the easily scandalized become so easily scandalized when a regulator mentions the benefits of insider trading. One question: why are so many of the easily scandalized also British?
[Editor's Note: The image above is of JP Morgan Chase CDS trader Gino Tzannatos. We illustrated this item with Gino's picture because it was one of the few nice looking pictures of a debt derivatives trader we could find. Nothing in this item is intended to imply that Gino has ever violated any securities laws, engaged in insider trading, done anything unethical or behaved in a particularly British manner.]
[Correction: An earlier version of this item made a clearly erroneous statement about the current state of the law with respect to credit default swaps. This has been corrected and clarified.]

SEC Official: Insider Trading Makes for Efficient Markets
[Portfolio.com]
Earlier from Felix Salmon: Does the SEC regulate the CDS market? [felixsalmon .com]
Earlier on DealBreaker:As It Turns Out, Some CDS Trades May Be Made With Inside Information [12.14.06]

Related