International regulators are joining forces to strike against what they deem as “opportunistic strategies” and “manufactured credit events” in the multi-trillion-dollar derivatives marketplace.
“The continued pursuit of various opportunistic strategies in the credit derivatives markets, including but not limited to those that have been referred to as ‘manufactured credit events,’ may adversely affect the integrity, confidence, and reputation of the credit derivatives markets, as well as markets more generally,” wrote Commodity Futures Trading Commission Chairman J. Christopher Giancarlo, Securities and Exchange Commission Chairman Jay Clayton, and U.K. Financial Conduct Authority Chief Executive Andrew Bailey, in a joint statement. “These opportunistic strategies raise various issues under securities, derivatives, conduct and antifraud laws, as well as public policy concerns.”
At issue is a small, but growing, trend of companies purposefully defaulting on credit default swap contracts. By doing so, they allow themselves or a third party to collect on a previously issued credit default swaps. In the latter scenario, the arrangement is often part of a contingency plan for a separate deal or a quid pro quo that benefits both parties to a leveraged loan deal (notably investment firms and so-called “vulture capitalists” that can profit through the dismantling of corporate assets). Recent cases involving such a maneuver have included homebuilder Hovnanian, telecom provider Windstream, and former retail giant Sears.
Credit-default swaps are, in simple terms, an insurance-like financial instrument used to compensate lenders when a company becomes insolvent, liquidates assets, or restructures debt through a bankruptcy reorganization. The products were largely blamed as a contributing factor to the global financial crisis of 2008.
The latest statement from the trio of international regulators says their agencies will “make collaborative efforts,” including industry input, to address these concerns “and foster transparency, accountability, integrity, good conduct and investor protection in these markets.”
The first warning shot against the practice came in April 2018, with an advisory from the CFTC’s divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight on manufactured credit events in connection with credit default swaps (CDS):
“The CDS market functions based on the premise that firms referenced in CDS contracts seek to avoid defaults, and as a result, the instruments are priced based on the financial health of the reference entity,” the statement says. “However, recent arrangements appear to involve intentional, or ‘manufactured,’ credit events that could call that premise into question.”
The CFTC divisions notes that the International Swaps and Derivatives Association’s board of directors also criticized manufactured credit events, writing that they “could negatively impact the efficiency, reliability, and fairness of the overall CDS market,” and indicated that it advised its staff “to consult with market participants and advise the Board on whether…amendments to the ISDA Credit Derivatives Definitions should be considered.”