The increasing use of credit default swaps in the loan market is raising concerns over how to control private information from flowing into the public markets and loan participants want to get ahead of the development before the Securities and Exchange Commission takes an interest. The issue has arisen as banks attempt to better manage portfolios through derivatives and as more hedge funds and multi-strategy funds seek to invest in bank debt, bonds and the credit derivative markets.
"The issue is the biggest flashpoint for most institutions," according to Peter Vaky, managing director and head of syndicated finance for SunTrust Robinson Humphrey Capital Markets. The Loan Syndications and Trading Association is in the process of developing guidance to prevent dissemination of non-public information, noted Jane Summers, general counsel.
Bank loans are private agreements so lenders are privy to information not available to public bond holders. This distinction becomes touchy when players are dealing in the loans and bonds of the same company. More recently, the private nature of loans has become an issue with lenders acting on this information to hedge their exposure with credit default swaps. Both issuers and investors could get harmed. Investors would be damaged because having inside information is taking advantage of the system and the public at large, Vaky said. "You can damage a company's reputation if you start trading on stuff and push the price of the bonds down," he added. Vaky believes that most institutions have learned how to deal with the crossover between bonds and loans.
But now the grey area is the CDS market. A lot of traders and portfolio managers will use CDS as hedges and the reason they are using the hedge is because they got private information that is of concern, Vaky said. He said SunTrust makes sure it goes through the process with "some arm's length." The bank is careful not to tell private information to the CDS trader. "If we use CDS, we make sure that we still stay on the private side of the wall," he added.
"Credit default swaps that reference a publicly traded security have characteristics of securities so they raise the concern of trading on the basis of non-public information," explained Pat Sweeny, a partner with Ballard Spahr Andrews & Ingersoll. He said financial institutions need to put the same protective safeguards into place for credit default swaps as they have for securities to ensure that neither the institution--nor its employees--enter into CDS transactions on the basis of non-public information.
CDS has been hot for the last 18-24 months, but the public/private issues have only been looked at in the last 12 months, Vaky noted. "It's sort of a tangential issue driven more from the regulatory or concern side from funds and banks, making sure they don't get into the situation that some funds have," he added. "No one wants to get in trouble where they are paying millions of dollars in fines." Sweeny said there are two possible repercussions for a firm that uses non-public information in connection with an investment in credit default swaps. "The SEC might initiate an enforcement action against the financial institution for failing in ensuring non-public information would not be misused in this matter," he noted. "In addition, there is the possibility of a private lawsuit again the financial institution on behalf of the market participants who consider themselves defrauded."