The National Conference of Insurance Legislators is drafting model legislation for states that would require the regulation of companies that buy and sell credit default swaps, including muni CDS.
NCOIL, a group of state legislators who have oversight authority of insurance companies, announced the effort last Wednesday.
The legislation would require all CDS sellers to be treated like monoline insurers, such that they would be required to meet certain reserve requirements and pass solvency tests. CDS buyers would be required to have some exposure to the credit event from which their CDS were derived. In other words, a company would not be allowed to buy a CDS on a bond or other credit it does not hold.
The focus of NCOIL's legislation is not on the CDS contracts themselves or whether they clear on an exchange, said the group's CDS task force chairman, Assemblyman Joseph Morelle, D-N.Y.
The legislation would be designed to take back regulatory authority the states lost when the Commodity Futures Modernization Act passed in 2000, he said.
American International Group Inc.'s "problems are not insurance problems, they're largely CDS problems," Morelle said. "If it hadn't been for Congress intervening in 2000 with the Modernization Act and precluding the states under our gaming laws from being able to regulate the naked swaps, we may very well have avoided this."
Meanwhile, muni CDS dealers are standardizing their contracts to help boost volume and to prepare for the possibility that they will be required in the future to trade their contracts on a clearing facility, market participants said.
The handful of large firms that underwrite and trade muni CDS are making the changes as trading volume has fallen since Lehman Brothers Holdings Inc. filed for bankruptcy in September, dealers said. They are working together on their own for now but may join with the International Swaps and Derivatives Association, the trade group that represents over-the-counter derivative participants, to finalize the standardization process.
Last Wednesday, the ISDA announced that it had finalized standards for corporate and other CDS contracts, but said the standards do not cover muni CDS. The contracts were streamlined to contain standard auction settlement terms, which determine how the contracts will be settled if credit events occur.
The muni CDS dealers are crafting similar measures to make it easier to net contracts and remove ones that are redundant or that overlap from the market, they said.
Regulators have focused on the opaque CDS market after AIG was downgraded one day after Lehman filed for bankruptcy. At that time, the CDS market was estimated to be $62 trillion - a figure traders said did not represent counterparty risk and was inflated because it included contracts that overlapped. Muni CDS comprised about $250 billion of the overall market at that time, according to the traders.
Still a sliver of the total market, outstanding muni CDS may have shrunk to as little as $50 billion, traders estimated last week. The figure is difficult to gauge, they said, because there is no central clearing process that records trades.
However, the traders agreed that market volume has decreased since its peak in September. Firms that traded $1 billion of muni CDS weekly in September may be trading only $250 million a week now, they said, adding that some muni CDS participants have left the market in the flight to quality since the credit freeze.
The muni CDS traders are hoping contract standardization will reduce the counterparty risk that has raised concerns for some market participants. The decrease in trading has spurred efforts to standardize contracts, the traders said, but the complicated process means there is still work to be done.
Several exchanges have said they would be willing to clear muni CDS, including the Chicago-based Clearing Corp., the Atlanta-based InterncontinentalExchange Inc., and the Chicago-based CME Group Inc. Both ICE and CME received federal approval to clear CDS in March.
Traders said the downgrades of monoline insurers and the threat of muni defaults could attract participants back to the CDS market. One trader said the spread on California CDS currently is about 300 basis points, compared to 20 basis points 18 months ago. A basis point on a CDS contract protecting $10 million of debt from a credit event for five years equals $1,000 a year.
