Lawmakers may call for ban on ‘naked’ trading of credit default swaps

Congress may be willing to go further than the Obama administration in regulating over-the-counter derivatives by banning “naked” credit default swap trading, leading lawmakers said.

Barney Frank (D-Mass.) and Collin Peterson (D-Minn.), chairmen of the House Financial Services and Agriculture committees, respectively, left open the possibility of such a ban in a joint “concept paper” setting forth a framework for legislation to regulate derivatives.

The two committees have oversight of the two regulatory agencies charged with reining in derivatives trading – the Securities and Exchange Commission and the Commodity Futures Trading Commission.

Credit default swaps(CDS), private contracts between counterparties that provide insurance against defaults on bonds, have been cited for exacerbating the subprime mortgage collapse that led to the current financial crisis.

Some 80% of CDS are estimated to be held by speculators who do not own the underlying security. These “bets” against certain issuers have been blamed for driving down the market perceptions of Bear Stearns and Lehman Brothers before they collapsed.

SEC officials have complained that naked shorting using CDS is hampering their efforts to stop abuses of naked shorting of securities.

In their concept paper, the two lawmakers suggested that one option for curtailing speculation would be to place a limitation on who may trade CDS. Another option would be to monitor the short positions of all derivatives traders.

In the case of a ban, trading in CDS would be limited to those who own the underlying security or own one of the securities in an index, or to those who are legitimate hedgers or market makers.

The concept paper also calls for all standardized derivatives to be cleared at a certified clearing house. It recommends that participants should be incentivized, by lower margin and capital requirements, to trade derivatives on an exchange or electronic trading platform.

The Obama administration’s plan for regulating derivatives also seeks to push traders toward clearing house transactions, but does not call for specific limitations on CDS trading.

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Posted : Friday 31 July 2009 20:30 | Managing Editor

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