Engineered Credit Default Swaps: Innovative or Manipulative?

Credit default swaps (“CDS”) are, once again, making waves. Maligned for their role in the 2008 financial crisis and condemned by the Vatican, investors are once more utilizing CDS to achieve results of questionable market benefit—and, globally, financial regulators are starting to pay attention. In a joint statement issued in June 2019, the Securities Exchange Commissions (“SEC”), the Commodity Futures Trading Commission (“CFTC”), and the U.K. Financial Conduct Authority (“FCA”) condemned what they called “various opportunistic strategies in the credit derivatives market” because of the negative effect these transactions have on the integrity and reputation of the credit derivatives markets. Seven years after the first engineered CDS transaction, financial regulators are taking note and expressing disapproval of the strategies CDS counterparties employ to guarantee the profitability of their CDS positions. However, the narrowness of their focus and the limitations of applicable laws restrict regulators’ ability to effectively address opportunism in the CDS market.

In an article forthcoming in the New York University Law Review, Engineered Credit Default Swaps: Innovative or Manipulative?, I analyze the opportunistic strategies that counterparties employ to “engineer” the outcomes of their positions, thereby guaranteeing that their CDS transactions are profitable. CDS allow counterparties to take a position on whether a debt issuer, such as a company or sovereign, will default on its debt obligations. One party, the protection buyer, pays periodic premiums to another party, the protection seller and, in exchange, the protection seller agrees to compensate the protection buyer if the issuer defaults on its debts. However, rather than waiting to see if their positions pan out, some CDS counterparties collaborate with the debt issuer to guarantee their preferred outcomes. Currently, under the terms of the CDS contracts, these engineering schemes are not prohibited—but they have roiled the credit derivatives markets as market participants and regulators debate whether and how to address them.

Despite condemnation from regulators, the market response to engineered CDS transactions has been mixed. Whereas some view engineered CDS as a useful innovation in the credit markets that have opened new financing pathways for distressed companies, others view them as an exploitation of CDS that may constitute market manipulation. In this Article, I engage with the ongoing debate on engineered CDS transactions, specifically regarding their relative costs and benefits and, ultimately, their legality. In the Article, I argue that even though engineered CDS transactions provide some benefits to distressed issuers, their negative externalities on the market warrant legal intervention to minimize the ex post and ex ante consequences to third parties. However, I disagree with the financial regulators’ assessment that engineered CDS transactions constitute market manipulation under existing anti-manipulation laws and regulations. Rather, as this Article demonstrates, these transactions, like other forms of financial innovation, are beyond the reach of existing public laws and private rules. Therefore, in light of their severe negative externalities, it is necessary to curtail engineered CDS transactions within the market by deterring market actors from engaging in them.

With the aid of case studies, the Article expands the focus on opportunistic strategies in the CDS market to consider not only manufactured defaults, but also two other strategies CDS counterparties have employed to date: avoiding default and negating default. In creating a typology to classify and explain the different engineering strategies that counterparties use to guarantee the profitability of their CDS positions, I demonstrate that these strategies are available to both credit protection buyers and credit protections sellers in a CDS transaction. Further, regardless of the strategy used, the consequences on the market are similar, thereby requiring regulatory focus on all three potential strategies.

Given that credit derivative market participants are sophisticated, there appears to be limited justification for legal intervention—if the costs of engineered CDS transactions are outweighed by their benefits or internalized by CDS counterparties and the issuer, the resulting transaction would presumably be net positive or net neutral. However, if engineered CDS transactions externalize costs to third parties with little-to-no commensurate benefits, then legal intervention would be necessary to limit these transactions. Thus, the Article undertakes an in-depth analysis of the ex post and ex ante consequences of engineered transactions on three sets of actors: (i) issuers who participate in engineered transactions; (ii) CDS counterparties who have bought or sold protection on the issuer; and (iii) third parties that are unconnected to the engineered transaction or the CDS market. Through this analysis, I conclude that engineered transactions result in positive externalities for issuers and, at best, maintain the status quo of CDS as zero-sum transactions for counterparties. However, engineered transactions inflict negative externalities upon third parties, including diminishing pricing efficiency, impairing market integrity, and imposing costs on non-CDS investors. Furthermore, the market cannot reduce the negative externalities on third parties, owing to inherent informational asymmetries and the limited ability of CDS traders to force their counterparties to change their behavior.

The negative externalities of engineered transactions coupled with the impotence of market discipline in limiting the associated costs together justify legal intervention to limit engineered CDS transactions. The Article examines the capacity of the three sources of law pertinent to CDS and the CDS market to effectively cabin the attendant consequences of engineered transactions. The analysis illuminates the shortcomings of statutory, contract, and private laws in limiting the negative externalities that arise from engineered CDS transactions. Indeed, engineered CDS transactions do not involve fraud or misrepresentation, and the parties involved typically comply with their obligations to disclose material information once they have agreed to the terms of the transaction. As such, it is unlikely that these transactions violate federal anti-manipulation laws and regulations. Further, under the terms of the CDS contract, the covenant of good faith and fair dealing does not invalidate engineered transactions. Further, this Article assesses ISDA’s recently proposed (but not yet adopted) response to engineered transactions and finds that despite some positive attributes, it is too narrow to meaningfully respond to engineered CDS transactions.

Finally, the Article puts forward three proposals aimed at curbing the availability and attractiveness of engineered transactions to CDS counterparties. First, it suggests an expansion of ISDA’s proposal to make it more broadly applicable to all forms of engineered transactions. Second, it recommends regulatory interventions to impose good faith obligations on CDS market intermediaries, thereby extending the duty of good faith and fair dealing to CDS contracts. Third, it proposes expanding the definition of price artificiality under anti-manipulation laws to include legitimate but distortive trading strategies that negatively impact the market’s price discovery process.

The full article is available here.