Regulators Target Manufactured Credit Events

A joint statement from US and UK regulators signals a continued scrutiny on so-called “manufactured credit events” in the credit derivatives market.

The statement, from US Commodity Futures Trading Commission (CFTC) chair Christopher Giancarlo, US Securities and Exchange Commission (SEC) chair Jay Clayton, and UK Financial Conduct Authority (FCA) chief executive Andrew Bailey says, “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.  These opportunistic strategies raise various issues under securities, derivatives, conduct and antifraud laws, as well as public policy concerns.

“As a result, today the chairmen and chief executive of our respective agencies announce that the agencies will make collaborative efforts to prioritise the exploration of avenues, including industry input which will address these concerns and foster transparency, accountability, integrity, good conduct and investor protection in these markets,” the statement adds. “These collaborative efforts would not, of course, preclude other appropriate actions by our respective agencies or authority.”

Manufactured credit events generally involves a borrowing defaulting on a finance agreement in return for a lower cost loan. Under the process, the provider of the original loan buys a credit default swap on the borrower and is paid out, often in size, in the event of a default, however this has raised criticism, including legal action, from the sellers of the CDS, who argue it amounts to fraud.

Last year the CFTC said in a statement that deliberately triggered defaults could be considered market manipulation. Elsewhere, ISDA’s board issued a statement last year noting that incidences of “narrowly tailored” credit events were apparently increasing. The statement said,  “We believe that narrowly tailored defaults, those that are designed to result in CDS payments that do not reflect the creditworthiness of the underlying corporate borrower (the reference entity in the CDS), could negatively impact the efficiency, reliability and fairness of the overall CDS market. We have therefore instructed the ISDA staff, as part of its ongoing dialogue with the market, to consult with market participants and advise the Board on whether further amendments to the ISDA Credit Derivatives Definitions should be considered.”

In October 2018, ISDA outsourced management of the Determinations Committee (DC) to a subsidiary firmer, DC Administration Services, meaning it would no longer participate in determining whether an event had occurred. The DCs comprise 10 sell-side and five buy-side voting firms, alongside consultative firms and central counterparty observer members. These firms are responsible for determining whether credit events have occurred in the credit default swaps market by comparing publicly available information on particular events with the legal definitions contained in market-standard credit derivatives documentation. A supermajority decision (12 out of 15) is required for a credit event to be declared, or for the DC rules to be amended.

James Coiley, derivatives partner at law firm Ashurst, says, “This follows in the wake of previous statements from both sides of the Atlantic. It seems that the regulators have felt it necessary to keep up the pressure notwithstanding industry efforts to address these concerns by way of changes to standard documentation.”

Colin Lambert

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