Wall Street's shady swap trades spark pushback from regulators

Wall Street's push to clean up a $10 trillion corner of the derivatives market is getting poor reviews from an important audience: global financial regulators.

Behind closed doors, watchdogs from Washington to London have made clear that a fix the industry came up with this year to crack down on shady deals falls short of what's needed, said people familiar with the matter. The focus of the scrutiny is credit default swaps -- instruments tainted by the 2008 financial crisis that traders use to cash in when companies miss bond payments.

The pushback hasn't been subtle. Staff members at the Commodity Futures Trading Commission, the U.S.'s main derivatives regulator, prepared an internal analysis in recent weeks that concluded hedge funds can still profit from CDS in numerous ways by engineering questionable corporate actions, three people said. The agency has shared its findings with other regulators.

In June, the U.S. Securities and Exchange Commission and the U.K.'s Financial Conduct Authority joined the CFTC in issuing a rare public statement in which the watchdogs pledged to work together to combat "opportunistic strategies" involving CDS. And the CFTC took the extraordinary step of hosting a July podcast for agency officials to discuss red flags they're seeing in the market, and how deals are proliferating with seven occurring in the past six months.

The change the industry proposed in March addressed situations where hedge funds have enticed stressed companies to miss bond payments they could otherwise make. But other trades continue to pop up, including instances of funds persuading corporations to alter debt terms to impact CDS prices.

For someone on the other side of a trade, such strategies can feel like manipulation that costs them a lot of money. That's because even minimal changes to companies' credit profiles can lead to substantial earnings in the CDS market, where valuations are based on the perceived likelihood of businesses defaulting or going bankrupt.

The heightened scrutiny -- notable at a time when authorities are dialing back financial rules during the Trump administration -- shows regulators are losing patience and might take action to force the industry to change its ways. At the core of their frustration: Wall Street seems to be resorting to increasingly creative ways once again to profit from CDS, instead of using the derivatives primarily for what they were initially created for -- hedging bond investments against the risk of companies and governments defaulting.

"The SEC is working closely with the CFTC and the FCA to examine the various issues raised by the pursuit of manufactured credit events and other potentially manipulative strategies," the SEC said in a statement released by Chairman Jay Clayton's office. "SEC staff welcomes continued engagement with market participants on these matters."

Michael Short, a spokesman for CFTC Chairman Heath Tarbert, said that in certain circumstances, CDS trades can raise "critical questions of whether there is market manipulation, and we are looking very closely at it."

The FCA declined to comment.

Representatives for Wall Street firms say they get it that regulators are concerned. But some tied to the industry want authorities to explain precisely what they don't like and what should be changed.

"If regulators want to improve the market -- and I applaud their efforts -- I would really encourage them to share their specific concerns, including concrete examples of transactions they see as potentially harmful to the markets, so we can roll up our sleeves and get to work together," said John Williams, a law partner at Milbank who represents clients who are active in the swaps market.

CDS have long had a bad reputation. In 2008, they had a starring role in the meltdown because American International Group, which sold billions of dollars of CDS tied to mortgages, received a massive taxpayer bailout when the housing market collapsed. Now, the questionable practices are in the corporate arena.

One of the most controversial recent deals emerged in late 2017 after a Blackstone Group unit agreed to extend sweetheart financing to Hovnanian Enterprises with an unusual catch: the struggling homebuilder had to default on a small slice of its debt. Blackstone stood to benefit from the transaction because it had purchased CDS on Hovnanian. The transaction was ultimately scuttled amid opposition from the CFTC.

More than a year later, representatives from firms including Goldman Sachs, JPMorgan Chase, Apollo Global Management and Ares Capital agreed to a plan intended to ensure that defaults are tied to legitimate financial stress, not traders' derivatives bets.

The International Swaps and Derivatives Association, the industry's main lobbying group, unveiled the changes in March. They were approved last month, and will probably take effect in 2020.

But as regulators continued to examine CDS trading, they concluded the changes didn't address enough of the practices that they believe are undermining market confidence, said the people who asked not to be named in discussing internal deliberations.

ISDA CEO Scott O'Malia said the industry's fix targeted a subset of transactions and firms are receptive to regulators' concerns. He added that derivative traders are already subject to laws prohibiting fraud and manipulation.

"We welcome the focus by regulators on this market, and will work closely with them in response to specific issues that are identified," O'Malia said in a statement.

In the past year, multiple trades have raised eyebrows among market participants. Examples include hedge funds pushing Neiman Marcus to tweak terms of a debt swap in a way that could boost CDS payouts if the retailer later defaults. Funds also persuaded bankrupt Sears Holdings Corp. to auction off what would normally be a worthless chunk of debt to boost their earnings from swaps.

Still, it's unclear how far regulators can go -- or are willing to go -- to regulate the CDS market. One issue is that it's questionable whether any of the deals that have gotten attention actually violate the law. Thus far, none have triggered enforcement actions.

Plus, former CFTC Chairman J. Christopher Giancarlo, one of the most vocal critics of trades designed to trigger CDS windfalls, left the U.S. government last month. Going forward, instituting any reforms will probably fall on the SEC and FCA. That's because many of the controversial strategies involve CDS contracts that insure against default by a single company, which the CFTC doesn't regulate.

Regardless, watchdogs may not be able to keep up with Wall Street's craftiness.

"There will be creative people who can come up with ways of circumventing even this," Julia Lu, a law partner at Richards Kibbe & Orbe whose specialties include derivatives, said of ISDA's changes. "There is no good way to regulate it."