Manufactured credit events may be market manipulation and “severely damage the integrity” of the credit default swaps markets, a US regulator said on Tuesday.
The Commodity Futures Trading Commission (CFTC) said in a strongly worded statement: “Manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets, including markets for CDS index products, and the financial industry’s use of CDS valuations to assess the health of CDS reference entities.”
“The CDS market functions based on the premise that firms referenced in CDS contracts seek to avoid defaults, and as a result, the instruments are priced based on the financial health of the reference entity,” the CFTC said.
“However, recent arrangements appear to involve intentional, or ‘manufactured,’ credit events that could call that premise into question.”
CFTC said that this would affect the entities that it is responsible for overseeing, including dealers, traders and clearing houses.
The statement comes in the wake of a controversial arrangement in which homebuilder Hovnanian plans an intentional default next month in exchange for a low-cost loan.
The loan was provided by GSO, the credit arm of Blackstone.
The default stands to deliver a handsome payout to GSO, which is a buyer of credit default swaps contracts on Hovnanian.
Hedge fund Solus, which sits on the opposite side of the CDS trade, has sued for damages, alleging the deal amounts to fraud and arguing that it perverts the functioning of the CDS market.
A spokesman from Solus declined to comment on the CFTC statement.
Hovnanian on Tuesday said: “We are aware of the statement issued today by the CFTC and remain confident that our recent transactions are in the best interests of the company and our shareholders.”
The statement from CFTC was released as the International Swaps and Derivatives Association (ISDA) kicked off its annual meeting in Miami.
ISDA said earlier this month that its board of directors had ordered consultations on possible changes to the handling of credit defaults.
“We believe that narrowly tailored defaults … could negatively impact the efficiency, reliability and fairness of the overall CDS market,” the ISDA board said.
“We have therefore instructed the ISDA staff … to consult with market participants and advise the board on whether further amendments to the ISDA Credit Derivatives Definitions should be considered.”
Those definitions, which were last updated in 2014, contain the standard terms used for most contracts in the US$1.5trn CDS market, including a description of what types of events constitute a default.
Speaking with reporters on the sidelines of ISDA’s annual meeting in Miami, the trade group’s chief executive Scott O’Malia said the CFTC statement was a welcome development to the discussion his organization and market participants are having about potential changes to credit derivatives contracts.
“This (the CFTC statement) really puts the spotlight on it,” O’Malia told reporters.
“It will be useful in terms of having that discussion … and as the board indicates in its statement we are committed to doing that. We have to let that process run and at the end of the day hopefully we get some good reforms.”
In its Tuesday statement, the CFTC also said: “Market participants and their advisors are advised that in instances of manufactured credit events, the divisions will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS, in coordination with our regulatory counterparts, when appropriate.”
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