CFTC Scrutiny Of Opportunistic CDS Strategies Extends Beyond Manufactured Credit Events

In Short

The Situation: Following its recent joint statement on opportunistic strategies in the credit derivatives market with the U.S Securities and Exchange Commission ("SEC"), the United Kingdom's Financial Conduct Authority ("FCA"), and the U.S. Commodity Futures Trading Commission ("CFTC") published a podcast providing greater detail and insight into the strategies it regards as problematic.

The Developments: During the past two and half years, the CFTC has observed a total of 14 instances where opportunistic strategies have been employed in the credit default swap ("CDS") marketplace, raising regulatory and legal compliance, market conduct, anti-fraud, and broader public policy concerns. CFTC staff have undertaken an analysis that has identified multiple ways buyers and sellers of protection sought to artificially influence a CDS contract's value to their benefit.

Looking Ahead: Participants in the credit default swaps market and restructuring practitioners should be alert to those situations identified by the CFTC. Participants in the credit default swaps market should be prepared for document requests and other outreach by regulatory authorities and take steps to ensure that their trading strategies have not and do not run afoul of the situations described below. A CDS is a credit derivative in which two counterparties agree to exchange a regular, fixed coupon for a one-off payment contingent on the occurrence of a credit event of a specified reference entity or obligation. The buyer of protection pays a premium to the seller of protection in order to receive protection against a credit event. As such, the trade comprises a premium leg (the fixed-coupon stream) and a protection leg (the one-off, contingent payment).

In the United States, the SEC regulates CDS on single names, loans, and narrow-based security indexes, and the CFTC regulates CDS based on broad-based security indexes. Because of the interconnectedness of the narrow-based and broad-based CDS markets, close coordination between the staffs of the SEC and CFTC can be expected, particularly in enforcement investigations.

On June 24, 2019, SEC Chairman Jay Clayton, CFTC Chairman J. Christopher Giancarlo, and FCA Chief Executive Andrew Bailey issued a joint statement regarding the credit derivatives markets. In that statement, they announced that their respective agencies would make collaborative efforts to halt the continued pursuit of various opportunistic strategies in the...