The US Congress is tipped to pass comprehensive legislation tightening oversight of the financial sector in the coming weeks. Such legislation will cover Credit Default Swaps (CDS), sovereign or otherwise, although a ban on naked selling, like some in Europe are calling for, is not on the cards.

US lawmakers, especially the Democrats who have majorities in both the House of Representatives and Senate, are keen to pass something soon as it is an ‘easy sell’ to the US public, which votes in Congressional elections this November. Unlike, for example, their draft legislation on climate change currently under consideration, financial sector reform has a strong populist appeal. There is seething resentment among Americans over having had to fork out US$700 billion - US$2,333 for every man, woman and child - to bail out Wall Street in late 2008. Moreover, the enactment, on 23 March, after a year-long gruelling battle, of US President Barack Obama’s health care legislation has reinvigorated the Democrats, giving them confidence - and time - to pass something on financial services.

Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), is one of the strongest advocates for regulating CDS. His goal is to have the supervisory regime known as clearing-houses in place by the end of 2012. Aware of the need for transatlantic cooperation given how integrated the EU and US money markets are, Gensler was in Brussels in March discussing the matter with the European Parliament. The EU and US account for 85% of the global trade in derivatives, of which sovereign CDS are a subset.

In terms of how the US moves forward, the first thing that needs to happen is for Congress to pass legislation authorising the CFTC and/or Securities and Exchange Commission (SEC) to adopt regulations. Presently, these two agencies are legislatively barred from regulating CDS (see separate article). The legislation would lay down some core goals and principles, while leaving it up the CFTC and/or SEC to work out the technical details. CFTC/SEC regulations are adopted through a «rule-making» procedure in which the public and industry are consulted on proposed rules before the agencies adopt a final rule, a process that typically takes at least a year. The SEC and CFTC were set up in the 1930s in response to the Wall Street crash of 1929 to supervise the securities and futures markets respectively.

ACTION ON CAPITOL HILL

One of the US’s lawmaking arms, the House, has already acted, passing a comprehensive bill (HR 4173) by 223 to 202 votes in December 2009. The bill covers CDS, notably requiring ‘clearing-houses’ or ‘swap execution facilities’ to be set up, which would be intermediaries that guarantee the CDS contract being negotiated complies with the regulations. Despite welcoming this move generally, the CFTC’s Gensler did criticise the bill for excluding certain privately-traded or over-the-counter CDS contracts from its scope.

The House bill requires CDS dealers to register with the SEC and mandates the CFTC to adopt rules within one year on swap dealers and major swap participants. The CFTC and SEC would also set minimum capital requirements for swap dealers to ensure that if a company or country does default, the seller of the CDS will have sufficient funds to cover all claims - potentially billions of dollars. But the bill notably does not prohibit actually trading in sovereign CDS. Congressman Barney Frank (Democrat, Massachusetts), chairman of the House Financial Services Committee, originally proposed a ban on naked CDS selling but it did not survive into the final version.

Over on the other side of Capitol Hill, the Senate Banking Committee passed its version of the bill, on 22 March, by 13 votes to ten and a vote on the full Senate floor is expected mid-April. Like the House version, it has provisions on clearing-houses and empowers the SEC and CFTC to regulate CDS but does not ban specific kinds of swaps. US President Barack Obama has not yet said if he thinks naked selling of sovereign CDS should be banned or restricted. On 15 March, he said simply that «all derivatives must be regulated» and pledged to work to «strengthen the bill and fight against efforts to weaken it».

One financial industry analyst doubted the wisdom of banning naked CDS selling. «It could make people who are not speculators but are hedging a genuine financial risk pay more for their CDS. This might discourage trade in CDS and consequently lower the amount of capital available on the market, which would ultimately push up interest rates on government bonds.» Higher interest rates are the very thing Greece wants to avoid to prevent it defaulting. US regulators temporarily halted another speculative practice, short selling, in September 2008, but quietly dropped the ban after it did not achieve the intended goal. The downside of banning any financial product is that it lowers capital availability, which in turn can reduce economic growth. And if, as is likely, the US stops short of banning naked selling of sovereign CDS, the wisdom of the EU introducing such a ban (see separate article) is dubious given that the largest dealers in CDS operate from Wall Street.

«Banning any financial product lowers capital availability, which in turn can reduce economic growth» 

US money saved EU banks

Of the US$700 billion bailout package for Wall Street in late 2008, US$45.7 bn ended up shoring up European banks including Deutsche Bank, Barclays, and Paribas. That happened because European banks had insured themselves with the US insurance giant AIG, which was the single largest recipient of the bail-out money. AIG needed to pay out European and US banks to keep the global financial system afloat.