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Regulators Race to Install CDS Rules Before Euro Zone Implodes

By Features FOXBusiness

The interconnected nature of the global financial system was on full display in 2008, bringing banks around the world to their knees despite the fact the toxic assets in question -- subprime mortgages -- largely originated in the U.S.

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Now the financial world is watching with fear as Europe’s scary sovereign debt crisis threatens to spread to core nations like France and the Netherlands in a cascade that could infect banks all over the globe.

At the heart of the crisis is the $35 trillion market for credit default swaps, a complex financial instrument used by large banking institutions to hedge risk. In a lot of ways, it’s like 2008 all over again. Three years ago CDS were instrumental in causing the domino-affect that nearly shut down global credit markets. That wasn’t supposed to happen again. 

But it is.

Concerns about exposure by major financial institutions to the crumbling euro zone underscore the need for regulators to implement new rules aimed at making the often-opaque market for credit-default swaps less dangerous.

“I’m very concerned. It’s kind of a race of implementing regulations and capital requirements against the dangerous things that are happening out there, particularly in the euro zone,” said Darrell Duffie, a finance professor at Stanford University.

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So what exactly are credit default swaps? They are derivatives (a security whose value is tied to that of another asset) that pay the owner in the event a given borrower defaults on its obligations. They can serve as a type of insurance contract on another investment such as sovereign bonds, or they can help speculators profit if they believe a borrower will fail to pay its obligations.

“It’s worse than gambling because they have no resources to pay off their debts. At least in Vegas the house has the money to pay off the winners. It’s gambling with no house.”

- Jim Rickards, senior managing partner at Tangent Capital

False Sense of Security?

Unlike futures and options, many of these contracts are only now beginning to go through clearinghouses, which require buyers and sellers to put up collateral and maintain certain reserve levels.

Similar to the ’08 crisis, CDS are coming to the forefront again today because banks have hedged their risk of suffering losses on bonds of euro-zone nations like Portugal and Italy in part through buying CDS on those countries.

Critics of how CDS are traded believe the instruments offer a false sense of security to regulators, investors and banks. That’s because it’s not always clear the counterparty at the other end of a trade has enough cash in reserve to pay if a major borrower, like Italy, defaults, triggering a series of contracts all at the same time.

“Until you analyze the sellers and until you ascertain the sellers have reserves, then you actually don’t know what you have,” said Jim Rickards, senior managing partner at Tangent Capital. “This is a problem for regulators and governments. They don’t have the answers either.”

Rickards believes CDS should be banned.

On top of this counterparty risk, there is a systemic danger: If a nation defaults on its debt, chances are its banks will be under severe pressure and will be unable to hold up their end of the CDS contract.

“As a result…the counterparties who thought they would be made whole, aren’t -- and this creates a panic,” said Luigi Zingales, a finance professor at the University of Chicago Booth School of Business and a member of the Committee on Capital Markets Regulation.

Rickards, who wrote Currency Wars and said he helped draft one of the first CDS contracts ever while he worked at infamous hedge fund Long-Term Capital Management, questioned the inherent value of the credit-default swap market in its current form.

“It’s worse than gambling because they have no resources to pay off their debts,” said Rickards. “At least in Vegas the house has the money to pay off the winners. It’s gambling with no house.”

Racing to Install Rules

In an effort to allay these fears, last year Congress passed the Dodd-Frank financial overhaul, part of which addresses derivatives. But while the SEC has proposed 13 rules in this area, none has been adopted, let alone implemented.

Duffie, who gave a speech to the New York Fed this week on the reform efforts, believes the four crucial areas this legislation addresses in regards to CDS are: rules mandating standardized CDS to be cleared, minimum collateral for any trades that don’t go through a clearinghouse, minimum capital requirements and increased transparency.

Regulators are scrambling to complete the new rules before a potential major credit event in or caused by Europe. The clock is clearly ticking on both sides of the Atlantic as the sovereign debt crisis deepens. Exposure to Europe has already caused one shock to the U.S.: the implosion of futures brokerage MF Global, which had more than $6 billion in net euro-zone exposure.

The SEC declined to comment directly, but Robert Cook, the agency’s director of trading and markets, said in recent testimony before Congress that CDS reform should be rolled out “in a logical, progressive, and efficient manner.” For its part, the Commodity Futures Trading Commission began finalizing its Dodd-Frank rules this summer and is still working on them. European policymakers are also working on similar reforms.

The clearinghouses charged with handling CDS  have been slow to adjust to the changes because of the huge risks involved.  

“Regulators and policymakers were probably hoping it would be faster, whereas people in the industry knew these things take time,” said Otis Casey III, the director of credit research at Markit, which provides CDS pricing data.

Still, this week IntercontinentalExchange (ICE) announced its CDS clearinghouses surpassed $25 trillion in cumulative gross notional value last week.

Lessons Learned?

As the financial world’s attention remains fixed on the euro crisis, it’s not yet clear if Wall Street learned from its’08 experience with credit-default swaps.

The memory of AIG (AIG), a huge seller of CDS, still looms large. When AIG collapsed in 2008, many banks, such as Goldman, were left exposed to huge potential losses. The $182 billion bailout AIG received from the U.S. government ended up making Goldman whole, however, creating another risk – that of moral hazard.

“Unfortunately the lesson that Wall Street has learned is that if you take a big enough gamble, there is no counterparty risk because the government will intervene,” said Zingales. “They’re not learning because they’re not being taught.”