New York Insurance Department superintendent Eric Dinallo told members of Congress yesterday that he will "delay indefinitely" the state's effort to regulate part of the credit default swaps market because of the federal government's efforts to regulate them. But he made the remark at a hearing where lawmakers and the agencies seemed far from agreement as to who should primarily regulate the CDS market.
In a related matter, Senate Agriculture Committee chairman Tom Harkin, D-Iowa, introduced a bill yesterday that would require all swaps and derivatives to be traded on regulated exchanges.
At a hearing held by the House Agriculture Committee, Patrick Parkinson, deputy director of the Federal Reserve Board's division of research and statistics, told lawmakers that both the Fed and the Commodity Futures Trading Commission are proposing to regulate exchanges or clearing organizations for CDS. He pointed out that the Fed, the Securities and Exchange Commission, and the CFTC last week signed a memorandum of understanding that established a framework for information sharing in this area.
The Fed wants to regulate CDS on an exchange that would be registered as a bank holding company. But committee chairman Rep. Collin Peterson, D-Minn., said during the hearing that the Fed "has no experience" with CDS and that these products should be regulated by the CFTC, which falls within the committee's jurisdiction.
"I would not go along with that," Peterson told Parkinson, saying he is concerned that CDS parties would be able to write their own rules, without congressional oversight, if the Fed took control of regulation.
The CFTC said it has experience from regulating futures and options to include CDS if it is traded on a public exchange, like the Chicago Mercantile Exchange in Chicago.
Meanwhile, Eric Sirri, director of the SEC's trading and markets division, said the commission could regulate CDS contracts if they are traded on a public exchange.
Currently, CDS are over-the-counter products and the SEC does not have regulatory oversight of swaps, except for anti-fraud and manipulation cases, which are covered by its anti-fraud rules, or futures and options, which fall under the CFTC, Sirri said.
If a derivative is "subject to individual negotiation" it is considered an OTC swap and outside the scope of SEC authority, he said.
However, the SEC's oversight of CDS would kick in once it is traded on an exchange - essentially making it a security, Sirri explained.
"The tools necessary to oversee this market effectively and efficiently do not exist," Sirri said. "Chairman [Christopher] Cox has urged Congress to repeal this swap exclusion, which specifically prohibits the SEC from regulating the OTC swaps market."
New York Gov. David Paterson proposed in September that the state regulate CDS as insurance contracts if investors own the underlying securities on which they are purchased. But in testimony before the committee, Dinallo said he would hold off on its plans "to avoid dislocation in the market."
Congress, Dinallo said, is "committed to comprehensive and effective federal oversight of credit default swaps." Any independent effort in New York would disrupt the federal regulation efforts, he said.
"We concede it is not good to have a segmented market" for CDS regulation, Dinallo said. "My office will be actively following and assisting the federal government's efforts."
A spokesman for the department said the decision to shelve plans to regulate part of the market does not have an impact on the proposed guidelines it outlined for bond insurers writing CDS transactions, which are set to take effect next year.
In a circular letter sent to bond insurers describing new "best practices" for financial guarantors, the department said it plans to limit bond insurers' activity in the CDS market to "those transactions in which the insurers' risk is roughly comparable to the amount and timing of risks assumed when directly insuring bonds."
"The restrictions are intended to preclude the possibility that CDS counterparties will present claims ahead of other insured parties or otherwise gain a preferred position as a consequence of the superintendent pursuing rehabilitation of liquidation against [a financial guarantor] in accordance with Article 74 of the insurance law," the letter said.
Municipal bond CDS traders have said that while corporate and mortgage-related rather than muni-related CDS are likely to be regulated, exchanges may provide more liquidity.
The estimated $250 billion muni CDS market - a sliver of the estimated $47 trillion total CDS market - grew from about $25 billion in spring 2007. Credit hedge funds have used muni CDS to profit from a variety of trading strategies while the traditional muni market is slowly coming to understand the product, traders said.