The CFTC Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight ("Divisions") warned that intentional or "manufactured" events intended to trigger credit default swaps ("CDS") "may constitute market manipulation." The Divisions asserted that the "CDS market functions based on the premise that [reference entities] seek to avoid defaults."
The Divisions agreed with recent ISDA criticism of manufactured events stating that they could "severely damage the integrity of the CDS markets." The CFTC advised market participants and their advisors that "in instances of manufactured credit events, the Divisions will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS, in coordination with our regulatory counterparts, when appropriate."
Commentary / Nihal Patel
Everyone knows an issuer doesn't want to default; what a handful of market participants have presupposed is, maybe, sometimes, they do. Recently, these market participants have created circumstances in which a technical default may be in the best interest of an issuer. As the CFTC notes, these actions have caused market participants to question some of the assumptions on which the CDS market is based. That is, while a default is generally something issuers want to avoid, perhaps it is more accurate to recognize that a reference entity will seek to achieve the best outcomes for itself and its stakeholders regardless of what that means for a CDS. This can be a hard thing to measure for contractual purposes. A reference entity is not a party to a CDS. Instead, the parties to the CDS (who are generally using the trade to bet on the financial health of the issuer or as insurance on an obligation of the issuer) must determine when the relevant payments must be made.
ISDA's (reasonable) response to these new situations was to ask, among other things, how the terms of derivatives contracts can be improved (to the extent they need to be) to better recognize that CDS are fundamentally aimed at the creditworthiness of the reference entity. The CFTC's response takes the inquiry in a different direction and raises new questions. The CFTC seems to be focused on whether a party to a CDS that is "manufacturing" defaults is manipulating the CDS market more broadly, as opposed to whether that conduct is fraudulent or otherwise deceitful towards its particular counterparty. As covered previously, courts are not necessarily going to assume this type of behavior is bad faith, and so the CFTC could be arguing that conduct that may be in "good faith" (as a contract matter) is nevertheless unlawfully manipulating the market at large.
Suppose, for example, that parties were to enter into a contract in which they each explicitly permitted the other side to engage in transactions with the reference entity that have the intent of creating or preventing a default by that entity. At that point, could the activity – wholly permitted by contract – constitute market manipulation? And if so, how does one define the relevant market that is being manipulated, given the bespoke nature of the relevant contract? The CFTC has very broad authority over fraud and manipulation (in particular, pre-Dodd Frank authority as to price manipulation, and the broader authority conferred by Dodd-Frank in CFTC Reg. 180.1), but in this statement, they do little to explain how that authority might be applied to the conduct at issue, conduct that is primarily of concern to sophisticated parties to bilateral derivatives contracts. An indication of how the CFTC authority might apply would be helpful for market participants to better understand the limits of their ability to contract.
Finally, it's worth asking why the CFTC is addressing this issue at all, given that the CFTC does not have jurisdiction over the products at issue – i.e., single-name CDS. The CFTC partly answers this question by noting that manufactured credit events could impact index CDS, and that the CFTC has oversight over a number of entities that engage in CDS transactions. While these are certainly connected, it does seem that potential manipulation in the single-name CDS market, a market intimately tied to the bond market, would be best addressed by the agency that possesses primary jurisdiction over both markets – the SEC.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
