It’s been apparent for some time now that the Securities and Exchange Commission was preparing to crack down on the use of inside information by traders in credit default swaps. Today the head of enforcement more or less made it official.
“The days of insider-trading scrutiny being focused almost solely on the equity markets are now gone,” SEC enforcement director Robert Khuzami said today at a New York legal conference on hedge-fund regulation.
The SEC brought its first insider-trading case tied to credit-defaults swaps in May, when it sued a Deutsche Bank AG salesman on claims he illegally fed information on a bond sale to a hedge-fund money manager. Prices on credit-default swaps, which insure investors against bond defaults, have surged before corporate takeovers in recent years, fueling speculation that traders are abusing inside information. The SEC has said since at least 2007 that it’s examining the trades.
As FT Alphaville explains, the SEC has been staffing up on derivatives experts.
In November alone, the SEC has retained the services of Richard Bookstaber – former risk manager, congressional expert witness, author of “A Demon of Our Own Design” and occasional FT Alphaville panelist — and Adam Glass.
Mr Glass was, until October, co-head of Linklater’s US structured finance and derivatives practice. Both he and Mr Bookstaber will be at the SEC’s freshly-minted division of risk strategy and financial innovation. That unit was established in September, and is helmed by Henry Hu, a law professor who knows a thing or two about derivatives.
The SEC is making a terrible mistake here. Federal securities regulations against insider trading apply only to insider trading in “securities.” Under traditional definitions of that term, credit default swaps would not count as securities and therefore not fall under insider trading rules. But the enactment of the Commodity Futures Modernization Act of 2000 changed that by declaring that although swaps were not securities, insider trading rule and other federal anti-fraud measures would still apply to if the underlying contract was a security. In short, insider trading rules now apply to CDS based on publicly traded corporate debt.
But it’s worth asking whether this was a mistake. Who exactly is being protected here? What are they being protected from?
Few of those trading in the credit default swap market were calling out for protection from insider trading. Many hedge funds and other debt-traders active in the credit default market lack the kind of internal controls and so-called “Chinese Walls” that investment banks and brokerages have had to build to prevent insider trading in securities. Most everyone involved in the CDS market is well aware that this is the situation.
A couple of years ago, Erik Sirri, then the director of the SEC’s division of market regulation, explained that the costs of insider trading laws in the CDS market probably outweigh the benefits.
You see, insider trading laws have efficiency costs but the government has made the decision that in the case of markets for securities those costs are outweighed by the gains in investor protection and investor confidence. Part of the reason for deciding things in this way is because the government, corporate America and the large brokerages want ordinary investors to feel confident they are playing on something of a level playing field with those with potentially better access to information.
But in CDS trades involving more sophisticated players trading more sophisticated financial products, it’s far from clear that this rationale applies. Do we really need to protect hedge funds from other hedge funds and investment banks in credit default swap trading? The enforcement and compliance costs with insider trading rules may outweigh the benefits.
To put it differently, shouldn’t the costs of policing this market fall on the people getting wealthy from it rather than the general taxpayer? Isn’t this just a distraction from the SEC’s core duty of protecting the ordinary shareholder?