• Bozidar Bogosavljev

Credit Default Swaps: Legal Gambling or Clear Market Manipulation?

Credit default swaps (CDSs), despite being relatively simple-to-understand financial instruments by definition, have become a contentious and misunderstood topic, especially after the 2008 financial crisis. This article aims to examine the nature and intended usage of CDSs, with a particular focus on how creative certain investors have been in their application, and highlight the dangerous economic environment which has been created in the CDS market due, in part, to a lack of substantive regulation surrounding this area of law.

In simple terms, a CDS is a financial swap agreement whereby one party insures the other party’s losses in the event, most commonly, of a debt default. One could view them as a kind of formalized way of shorting an asset, i.e., making a bet that a certain asset or entity will perform poorly, and, if it does, typically receiving an agreed-upon payout. In theory, CDSs are supposed to serve as a line of defense between the purchaser and the debt they are betting against, providing some form of safety net even in the unpleasant scenario that the underlying asset experiences a credit default – hence the name. Up until 2008, the majority of CDSs were, indeed, being used in such a way, but many of them turned worthless in the wake of the crisis. Today, more and more companies are resorting to activist investment strategies to ensure their CDSs create profits even if the underlying security, on its own, would not.

The Creative Investor

One of the most glaring examples of market abuse vis-à-vis CDSs came in 2017, when GSO Capital Partners offered to lend money to a financially troubled homebuilding company, Hovnanian Enterprise Inc. As part of that deal, however, Hovnanian agreed to default on some of its debt, which happened to be the underlying security for GSO’s CDS agreement with Solus Alternative Asset Management. In other words, GSO had made a bet with Solus that Hovnanian would default on its credit obligations, and then enticed Hovnanian to do just that, profiting off the CDS at Solus’s expense. This kind of situation, unfortunately, was nothing new, as investors had been resorting to manipulation of the CDS market for years prior to this. But the Hovnanian case really drew attention to the rising problem of poorly regulated and easily manipulable CDSs and sparked outrage in the investment community.

The Scope of the Problem

There is little doubt that some economists would consider the situation described above as little more than a shrewd investing practice. It is a well known and generally accepted interpretation of the Delaware General Corporation Law (DGCL) that it is a company’s responsibility to its shareholders to maximize profits, and if forcing a CDS-triggering event could create profits for the company, then, an argument could be sustained that it is alright for a company to do so. Additionally, if, as in a game of poker, for example, all the actors involved are roughly on par with each other in terms of access and information and can reasonably expect a lack of truth-telling to be present in the economic game they are collectively playing, then, surely, all sophisticated financial actors should expect their counterparties to have solely their own interests in mind and to devise such creative strategies to boost profits.

However, there is a fundamental issue with this line of thinking. A market designed around estimating a company’s creditworthiness – such as the CDS market – is crippled if this creditworthiness can be manipulated by third parties for their own gain. It runs afoul of the legitimate expectations of all parties involved, and it goes far beyond the expected “bluffs” one might find in a game of poker or its economic analogies. This logic can be found in many other areas of law regulating financial crime. A pertinent example is insider trading, where, despite accepting that some level of unfairness will always be present in the market, the legislators clearly stipulated that there is a line in the sand beyond which mere inequality is turned into legally unacceptable unfairness. In the case of a CDS, it seems self-evident that this line is crossed when those betting on a company’s success or failure are the also ones influencing its ability to fail or succeed.

This argument is further strengthened when we consider the true scale of the CDS market. A case in point is RadioShack, whose debt in 2015 equaled $1.4 billion, yet the total worth of CDSs relating to its performance came out to $23.5 billion. Clearly, every actor betting on RadioShack’s performance would have an incentive to nudge it one way or the other, but it is precisely in the interest of avoiding such an all-out struggle for influence – where, no doubt, the biggest players would rarely, if ever, lose on their bets, while the smaller ones would be largely powerless – that gambling spectators should not participate in the game itself.

Regulatory Response

Unfortunately, despite compelling arguments against CDS abuse in the financial industry, the legislative response to this problem has been lukewarm at best. To an extent, legislation like the Dodd-Frank Act attempted to regulate the CDS market and prevent foul play, but, in truth, it had only limited effect due to the wide array of tactics available to traders to circumvent its narrow definitions. Others have chimed in on the debate as well, such as the Commodity Futures Trading Commission, which stated that “event manipulations”, i.e. situations when a company manipulated certain economic events (such as defaults) for its own gain (such as getting a payout on its CDS), could be market manipulation, though caselaw on the matter is very sparse since cases in the area typically settle. Moreover, there is strong disagreement over what rules could be implemented to ameliorate the situation; while, for instance, the ISDA suggests putting in place clear-cut rules and precise definitions in order to avoid interpretation issues and tackle the most glaring issues surrounding CDSs, many influential analysts from Barclays have insisted that only a higher degree of flexibility could solve the matter and avoid possible loopholes, of which there are currently many. Whatever the solution may be, what is evident is that the CDS market is not regulated nearly as well as some other areas of the financial world, and potential investors should keep that in mind when dealing with these important – yet risky – instruments.

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