Compromising Positions

Will credit derivatives encourage more lending, or will they harm the interests of borrowers?

In recent years, syndicates have shrunk dramatically as banks have exited the lending business. That in turn has increased the importance of credit derivatives to the remaining lending institutions. Meanwhile, bond investors have bought credit derivatives as an easy means of shorting companies based on their credit quality.

Also behind the market’s expansion has been the availability and enthusiasm of counterparties willing to sell the derivatives. Insurance companies and, more recently, banks themselves sell credit derivatives as a means of earning premiums, taking on attractive exposures to diversify their exposures to others.

There’s reason to both hope for and fear the further expansion of the market. A study earlier this year by the Bank for International Settlements, a Switzerland-based consortium of central banks, found that most of the activity in the credit-derivatives market was concentrated in the hands of relatively few players. “Some elements of the market appear to be highly concentrated,” the report warned, noting that this “might give rise to market disruption if the firms concerned were to come under pressure.”

The question is, would spreading the risk among more players increase or decrease the magnitude of such disruption? —H.R.

Inside Insider Trading

The definition of potential insider trading in the credit-derivatives market is the same as it is for any type of security or security-based transaction. The foundation of the law lies in Rule 10b-5 of the Securities Exchange Act of 1934, which prohibits the purchase or sale of a security on the basis of material, nonpublic information about that security or its issuer. But the law has evolved with judicial interpretations of it.

The Joint Market Practices Forum developed by financial institutions to address concerns about such abuse in the credit-derivatives market draws on statutory, regulatory, and judicial definitions of insider trading. The following definitions and guidelines are drawn from the exposure draft of the forum’s guidelines for best practices:

Information is material if:

  • It is likely that a reasonable investor would consider the information important in making an investment decision.
  • The investor would view the disclosure of the information as having significantly altered the overall information available.
  • The disclosure of the information is reasonably certain to have a substantial effect on the security’s price.

Information is nonpublic if:

  • The information has not been disseminated generally to investors.
  • Insiders have not waited a reasonable time after disclosure before trading, with the reasonable period dependent on the circumstances of the dissemination.

Individuals who are prohibited from trading on such information include:

  • Insiders, including directors, officers, and controlling shareholders of a corporation.
  • Those who provide professional services to a corporation such as accountants, consultants, and lawyers.
  • Those who have engaged in a confidential arrangement with a source of information, such as a lender.
  • Those who pass along tips to others likely to act on the information, and those who receive tips on inside information.

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