Over-the-counter credit derivatives regulation in the U.S. is effected through:
* Isolated laws that provide legal certainty;
* Capital adequacy rules that influence trading activities of banks;
* Rules, recommendations and statements of preferred practices by industry associations, self-regulatory organizations and regulators that influence the trading activities, internal controls and risk management processes of market participants; and
* Initiatives by market participants to entrench an orderly and controlled market through standardization of documentation, trading and confirmations processing and settlement processes.
Legal Certainty For Credit Derivatives
Exclusion from regulation by the Securities and Exchange Commissionand Commodity Futures Trading Commission
The Commodities Futures Modernization Act of 2000 excludes swap agreements, including credit derivatives, from SEC and CFTC regulation. There are some exceptions, however.
(i) Anti-fraud, anti-manipulation and insider-trading regulation continues to apply to securities-based swaps transactions. Credit derivatives based or indexed on or otherwise related to the price, yield, value or volatility of securities or securities indices continue to be subject to such regulation.
(ii) The CFMA's definition of swap agreements excludes securities options and forwards, other than contingent forwards where the contingency is related to the creditworthiness of a reference entity.
Due in part to the CFMA, the credit derivatives market has evolved predominantly as a market for sophisticated institutions where participants are able to appreciate the risks associated with the products. As a result, many of the recent regulatory statements and recommendations to credit derivative market participants focus on potential systemic risks--such as risks arising from shortfalls in operational and risk management systems--to the broader financial markets and to the integrity of bank participants.
Credit derivatives and insurance law
According to the New York Insurance Department in a 2000 public non-binding opinion, derivatives under which payment is not conditional on a party sustaining actual losses on the reference obligations are not insurance contracts. Standardized credit derivatives are developed around the well-established principles that transactions that do not compel ownership of the referenced asset and, as such, do not create an insurable interest, are not insurance contracts.
A combination of certain features, however, increases the risk of a credit derivative being re-characterized as an insurance contract, such as:
(i) elimination of early-termination payments and all features of market-risk,
(ii) requirement of mandatory assignment of voting rights, and
(iii) inclusion of claw-back provisions that are similar to subrogation rights.
Certainty of safe-harbor under the Bankruptcy Code
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 clarified the statutory definition of swap agreements to include credit derivatives. It also states that the inclusion of transactions that do not qualify as swap agreements will not affect the safe-harbor for other qualifying transactions. Market participants are currently seeking clarification that the safe-harbor applies to close-out netting amounts derived from the close out of qualifying and non-qualifying transactions in the event of a counterparty bankruptcy.
The Bond Market Association and Loan Syndications and Trading Association published a Model Net Operating-Loss Order aimed at creating a standard, less restrictive, form of NOL orders for protecting tax assets--operating loss carryovers--during a bankruptcy. In the wake of bankruptcies such as Delphi, Northwest and Delta, courts have been persuaded to adopt NOL orders that allowed close out of outstanding physically-settled credit derivatives. These precedents aid legal certainty in the credit derivatives market.
Enforceability opinions on ISDA master agreements
The International Swaps and Derivatives Association has obtained U.S. law opinion on enforceability of termination and close out of transactions under the master agreement. Similar opinions have been obtained in forty-eight different jurisdictions, including all of the major markets for credit derivatives.
Regulatory Capital
In March 2006, the U.S. Federal Reserve Bank published a Notice of Proposed Rulemaking Implementing New Risk-Based Capital Framework with respect to Basel II. Basel II currently only covers credit-default swaps, total-return swaps and 1st or Nth-to-default swaps. While preserving the requirement that banks hold 8% of their risk-weighted assets, it significantly changes the methodologies for determining the amount of risk-weighted assets and includes methodologies that permit banks to use internal risk-measurement systems. For certain credit derivatives with qualifying counterparties, it allows banks to apply double-default treatment which permits taking into account that default and recovery are joint probabilities of the credit quality of the protection provider and the reference entity, an approach with potential risk-mitigating benefits. For credit derivatives to qualify as risk-mitigants for regulatory capital purposes, certain legal documentation standards are required such as inclusion of failure-to-pay and bankruptcy credit events, among others. Basel II applies haircuts to the amount of any capital relief for exclusion of restructuring credit event and for mismatches in maturity, settlement currency or valuation obligation.
Recommendations And Statements Of Preferred Practices
* In March 2005, the Basel Committee on Banking Supervision published Credit Risk Transfer. This publication contains a set of recommendations for banks and regulators on internal control systems and risk management capabilities needed for credit derivatives trading. The recommendations include: a role for senior management in setting up and enforcing a risk-management framework, use and limitations of credit-risk valuation models, and managing liquidity, counterparty credit and operational risks.
* To minimize risks of fraud, manipulation and insider trading in the credit risk trading markets, industry associations published the Statement of Principles and Recommendations Regarding the Handling of Material Nonpublic Information. These are a set of recommendations that are designed to guide participants in maintaining information walls, policies and procedures to separate private-side activities and material non-public information from public-side activities.
* In highly-structured financing arrangements that use credit derivatives, U.S. regulators' Revised Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities, when finalized, may be a relevant guide. Also, the NASD's Guidance Concerning the Sale of Structured Products may be relevant. The NASD guidance contains recommendations on disclosure and suitability standards.
Financial Accounting, Disclosure Requirements And Tax Treatment
Financial Accounting Standard 133 requires derivative instruments to be reported as assets or liabilities in financial statements. It also specifies the conditions for designating an instrument a hedge and monitoring the effectiveness of such a hedge in order to avoid recognizing mark-to-market gains and losses in periodic earnings reports.
Under Regulation AB, if a credit derivative transaction primarily provides credit enhancement for a registered asset-backed securities offering, the party providing such enhancement will be required to make selected financial disclosure if its maximum potential exposure exceeds 10% of the cashflow supporting the securities or full financial disclosures if such exposure exceeds 20%. For a credit derivative transaction that is primarily a cash-flow hedge, the 10%/20% threshold is determined based on a more stringent test: maximum probable exposure. Market participants are currently seeking clarification from the SEC on whether certain subsidiaries can satisfy disclosure requirements with the financials of their parent entities.
The U.S. federal--and sometimes non U.S.--tax treatment of credit derivative products is an important analysis that counterparties need to consider in consultation with tax advisors. Generally, most standardized credit derivatives would qualify as notional principal contract under U.S. Treasury Regulations, a characterization that carries certain U.S. federal tax consequences. Other differing tax treatments are possible. For example, depending on the nature of the contract's terms and the referenced asset, a credit derivative may be re-characterized, for tax purposes, as a put option, guarantee, insurance contract, futures contract, forward contract or debt instrument. The industry is studying the effects of a 2004 proposed regulation for contingent, non-periodic swap payments on credit derivatives.
Standardization
Documentation of credit derivatives
Market participants have, in the last few years, achieved an unprecedented level of standardization in credit derivatives documentation. Documentation is now standardized across reference credits--including sovereigns, municipals, corporates, or asset-backed issuers--as well as product types such as bonds, loans, preferred securities, asset-backed securities and securities indices.
Standardization of assignments
The ISDA Novation Protocols have set in place a process for assignment of credit derivatives to reduce the backlog of unconfirmed trades and reduce the risk of failed trades.
Standardization of trading and confirmations processing
To minimize backlogs and reduce errors, participants have set use of electronic clearing systems as an industry goal.
Standardization of the settlement process
Following a handful of significant bankruptcies, the market successfully implemented multilateral settlement and tear-up processes to avoid any problems resulting from the notional balance of derivatives contracts typically exceeding the actual amount of debt obligations of reference entities. Participants are discussing establishing a standard settlement protocol.
This week's Learning Curve was written by Chinedu Ezetah, director and counsel at Dillon Read Capital Managementin New York.
