United States: CFTC Scrutiny Of Opportunistic CDS Strategies Extends Beyond Manufactured Credit Events

In Short

The Situation: Following its recent joint statement on opportunistic strategies in the credit derivatives market with the U.S Securities and Exchange Commission ("SEC"), the United Kingdom's Financial Conduct Authority ("FCA"), and the U.S. Commodity Futures Trading Commission ("CFTC") published a podcast providing greater detail and insight into the strategies it regards as problematic.

The Developments: During the past two and half years, the CFTC has observed a total of 14 instances where opportunistic strategies have been employed in the credit default swap ("CDS") marketplace, raising regulatory and legal compliance, market conduct, anti-fraud, and broader public policy concerns. CFTC staff have undertaken an analysis that has identified multiple ways buyers and sellers of protection sought to artificially influence a CDS contract's value to their benefit.

Looking Ahead: Participants in the credit default swaps market and restructuring practitioners should be alert to those situations identified by the CFTC. Participants in the credit default swaps market should be prepared for document requests and other outreach by regulatory authorities and take steps to ensure that their trading strategies have not and do not run afoul of the situations described below.

A CDS is a credit derivative in which two counterparties agree to exchange a regular, fixed coupon for a one-off payment contingent on the occurrence of a credit event of a specified reference entity or obligation. The buyer of protection pays a premium to the seller of protection in order to receive protection against a credit event. As such, the trade comprises a premium leg (the fixed-coupon stream) and a protection leg (the one-off, contingent payment).

In the United States, the SEC regulates CDS on single names, loans, and narrow-based security indexes, and the CFTC regulates CDS based on broad-based security indexes. Because of the interconnectedness of the narrow-based and broad-based CDS markets, close coordination between the staffs of the SEC and CFTC can be expected, particularly in enforcement investigations.

On June 24, 2019, SEC Chairman Jay Clayton, CFTC Chairman J. Christopher Giancarlo, and FCA Chief Executive Andrew Bailey issued a joint statement regarding the credit derivatives markets. In that statement, they announced that their respective agencies would make collaborative efforts to halt the continued pursuit of various opportunistic strategies in the credit derivatives markets, including manufactured credit events. According to the agency heads, opportunistic strategies raise various issues under securities, derivatives, conduct, and antifraud laws, as well as public policy concerns.

The recent joint statement follows another statement issued a little over a year ago, on April 24, 2018, by the CFTC's Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight manufactured credit events in connection with CDS. That statement noted that manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets, including markets for CDS index products, and the financial industry's use of CDS valuations to assess the health of CDS reference entities.

Since the CFTC made that statement, the CDS industry has taken steps to curb manufactured credit events, culminating in the July 15 publication of the 2019 Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definitions. While promising, the amendments themselves are fairly "narrow" as they address only a few specific strategies.

In a podcast released on July 10, 2019, CFTC staff detailed several additional opportunistic strategies deemed problematic. According to CFTC staff, the most straightforward of these strategies is where a default is induced or default timing is altered. In this situation, a protection buyer may attempt to establish an agreement with the reference entity that includes a requirement that a default is artificially made in the reference obligation. Alternatively, a protection seller might establish a private financial agreement designed to prevent the default by the reference entity until after the maturity date of CDS contracts they have sold.

Another strategy identified by staff involved actions undertaken to alter the amount of reference obligations at a particular reference entity. For instance, according to the staff, a protection buyer may seek to either add new debt to the reference entity as part of a private financial agreement, or to artificially increase the amount of debt in a reference entity. This increases the default risk of the reference entity, driving up the cost of credit protection on that reference entity. Buyers can profit on such strategy even if no default occurs by unwinding their original trade at the increased price. Similarly, protection sellers can profit from a strategy known as "orphaning" by coordinating with the reference entity for the repayment of its debt, typically through a loan made to an affiliate of the reference entity, solely to reduce or remove the sellers' risk obligations. If there are no further reference obligations related to the CDS, sellers can continue to collect premiums without the risk of the reference entity defaulting.

CFTC staff also observed that, after credit events have occurred, protection buyers or sellers will take steps to increase the value of their positions by affecting the cost of reference obligations that would be deliverable into the CDS auction process. Buyers could employ a strategy to lower the bond valuation at auction that occurs after a default, while sellers could engage in a classic corner or squeeze in the bond market to prevent deliverable obligations from being delivered into an auction.

Finally, CFTC staff identified instances combining aspects of the above examples to magnify the benefit to both buyers and sellers of protection. A protection buyer, for instance, may enter into a private financial arrangement with a reference entity that includes the default requirement, but also work with the reference entity to issue bonds that trade at subpar values. This particular strategy ensures that protection buyers will receive a payout from their CDS contracts while also increasing the supply of deliverable obligations into the CDS bond auction, lowering the recovery rate and increasing the guaranteed CDS payout.

Meanwhile, sellers may engage in a private financial arrangement with a reference entity that is designed to move a default beyond the CDS contract maturity date and also decide to purchase protection that covers the time period into which the default has been pushed. This would allow the seller to continue collecting premiums on contracts that are unlikely to pay out while simultaneously allowing them to receive a payout when the reference entity eventually defaults in the future.

Five Key Takeaways

  1. CDS market participants can expect further action—either in the form of rulemakings, statements, or enforcement actions—by regulators going forward.
  2. CFTC manipulation authority is broad, particularly under new CFTC Rule 180.1. By outlining problematic scenarios, the CFTC is putting the marketplace on notice that opportunistic CDS strategies may result in CFTC action, including an enforcement action.
  3. Participants in debt restructurings must pay close attention to the problematic scenarios outlined by the CFTC. What may seem like a strategy to keep a company alive may be viewed by CFTC staff as a problematic, opportunistic CDS strategy.
  4. Many of the strategies outlined as problematic to the CFTC are illustrative of what the CFTC staff views as manipulative conduct outside the CDS marketplace. While courts may ultimately disagree with these views, derivative market participants will be well served to understand the staff's view, as enforcement investigation and proceedings are exceedingly costly and time-consuming.
  5. Market participants should review their policies and procedures to ensure that the problematic strategies listed above are explicitly highlighted as conduct the CFTC staff views as problematic, and appropriate safeguards should be taken if any strategy is being employed that could potentially be viewed unfavorably or as opportunistic.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions