New York State to regulate part of credit default swap market
By Daniel at 23 September, 2008, 7:50 am
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New York state to regulate part of CDS market
By Alistair Barr, MarketWatch
Last Update: 9/22/2008 7:05:00 PM
SAN FRANCISCO (MarketWatch) -Gov. David Paterson said Monday that New York will
begin regulating part of the $62 trillion credit default swap market next year
because a lack of regulation in that area of finance has contributed to the
current credit crisis.
At Paterson’s direction, the New York Insurance Department issued guidelines on
Monday that establish some types of credit default swaps as insurance, subjecting
them to state regulation.
CDS are a type of derivative contract that pay out in the event of default. These
types of derivatives have grown very quickly in the past 10 years because they
allow market participants to hedge against the risk of holding debt, while also
letting traders speculate more easily on the fortunes of companies.
While the market has ballooned, it remains lightly regulated. That’s sparked
concern that problems in the market could exacerbate stresses in the broader
economy and other financial markets.
Paterson’s office said the goal of regulating the swaps is not to stop sensible
economic transactions, but to ensure that sellers have sufficient capital and
risk management policies in place to protect the buyers, who are in effect
policyholders.
American International Group (AIG) was a big seller of protection in the CDS
market. The giant insurer wrote CDS-based contracts that guaranteed
mortgage-related securities known as collateralized debt obligations.
When the housing market began to slump last year, AIG suffered big write-downs on
the exposures, eventually pushing the company into the arms of the government in
an $85 billion bailout.
“At AIG, for example, insurance companies regulated by the state are required to
hold substantial reserves and as a result those companies are solvent and able to
pay claims,” Paterson said in a statement. “However, a major part of AIG’s
problems were created when credit default swaps were issued by a non-insurance
unit that did not hold sufficient reserves.”
The new guidelines establish that when the buyer owns the underlying security on
which they are buying protection then the swap is an insurance contract. Such
swaps will now be subject to regulation and can thus only be issued by entities
licensed to conduct insurance business, the Governor’s office said.
So-called naked swaps are not insurance and cannot be regulated by the state, it
added.
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