The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

Articles By Topic

By Topic: Credit Default Swaps

  • From Vol. 10 No.2 (Jan. 12, 2017)

    Best Practices for Fund Managers When Entering Into ISDAs: Negotiation Process and Tactics (Part One of Three) 

    In the world of hedge funds, trading of over-the-counter (OTC) derivatives in the form of swaps has become ubiquitous, as funds do so for many reasons, including to hedge certain risks, take speculative positions, access difficult-to-trade assets or employ synthetic leverage. See “What Is Synthetic Prime Brokerage and How Can Hedge Fund Managers Use It to Obtain Leverage?” (Apr. 2, 2010). Most dealers require a fund to execute a variety of complex documents prior to entering into swap transactions on a bilateral basis with the fund. The responsibility for reviewing and negotiating these documents can be a daunting task for a manager’s legal, compliance and operations professionals. In an effort to distill the complexities of these documents and the negotiation process, The Hedge Fund Law Report interviewed several experts that negotiate these agreements on a daily basis on behalf of their fund clients. In this three-part series, we review the various trading agreements required for a fund to engage in the OTC trading of swaps, explain certain key negotiated provisions in swap agreements, discuss common amendments requested by dealers and provide guidance on what are currently viewed as “market terms” for certain provisions. This first article provides background on the various agreements that govern swaps, explains how the Dodd-Frank Act has introduced additional complications to the documentation process and offers advice on best practices for negotiating with dealers. The second article will review the most commonly negotiated events of default and termination events in the trading agreements and offers suggestions for negotiating these provisions. The third article will analyze the key considerations for funds with respect to the collateral arrangements – the delivery of margin to mitigate counterparty risk – between the two parties. 

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  • From Vol. 10 No.1 (Jan. 5, 2017)

    A Fund Manager’s Guide to Calculating and Reporting Short Sales Under European Regulations

    E.U. Regulation 236-2012 (Regulation), in effect since November 1, 2012, imposed reporting obligations on short sellers of E.U. securities and regulated certain aspects of the credit default swap market. Compliance, however, is difficult due to a lack of available guidance on those reporting requirements. To help clarify these obligations for fund managers, a recent program presented by Advise Technologies (Advise) offered a comprehensive overview of the Regulation, emphasizing the reporting requirements for short-sellers and the calculation of reporting thresholds. Moderated by William V. de Cordova, Editor-in-Chief of the HFLR, the program featured Anna Lawry, counsel at Ropes & Gray, and Marye Cherry, E.U. regulatory counsel at Advise. This article summarizes the panelists’ key insights. For more on the Regulation from Lawry and Cherry, see “How Fund Managers Can Navigate and Avoid the Pitfalls of European Short Sale Reporting Obligations” (Dec. 1, 2016). For a review of U.S. short-selling rules, see “Impact of Regulation SHO on the Short Sale Activity of Hedge Fund Managers and Broker-Dealers” (Nov. 10, 2011). For additional insight from Advise, see our two-part series on how non-E.U. hedge fund managers can comply with E.U. private placement regimes: “Registration” (Dec. 3, 2015); and “Reporting” (Dec. 10, 2015). 

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  • From Vol. 9 No.3 (Jan. 21, 2016)

    Hedge Funds and Others May Be Eligible to Collect Proceeds From $1.86 Billion CDS Antitrust Settlement

    On January 11, 2016, Quinn Emanuel announced the $1.86 billion settlement of a class action lawsuit alleging that, since 2008, major banks had conspired with the International Swaps and Derivatives Association and financial information services firm Markit Group to limit transparency and competition in the credit default swaps (CDS) market by thwarting attempts to create an exchange for trading CDS. The plaintiffs estimated that the defendants’ conduct inflated bid/ask spreads on CDS by 20% on average, amounting to damages between eight and twelve billion dollars. The U.S. District Court for the Southern District of New York has issued an order establishing a class of plaintiffs, identifying covered CDS transactions and preliminarily approving the settlement. Market participants covered by the class action plaintiffs – including hedge funds, pension funds, asset managers and other institutional investors that purchased certain CDS – have a limited time to opt out of the settlement class before final approval of the settlement. This article documents the history of the litigation and the plaintiffs’ claims, and summarizes the settlement terms. For coverage of another antitrust suit involving financial market participants, see “Federal Antitrust Suit Against Ten Prominent Private Equity Firms Based on Allegations of ‘Club Etiquette’ Not to Jump Announced Deals Survives Summary Judgment Motion” (Apr. 11, 2013).

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  • From Vol. 8 No.8 (Feb. 26, 2015)

    Interest Rate Swap Compression for Hedge Fund Managers: Mechanics, Fee Savings, Risk Consequences and Regulatory Context

    Hedge funds with exposure to interest rate swaps and other derivatives pay considerable fees to clearing brokers and futures commission merchants to clear such derivatives.  Further, changes in the relevant regulatory environment – including Basel III, MiFID 2 and the U.S. and U.K. clearing mandates – may result in significant fee increases.  In an effort to minimize such fees, hedge funds are exploring strategies such as netting and compression of interest rate swaps.  The Hedge Fund Law Report recently interviewed Tom Lodge, Partner at London-based Catalyst Development Ltd., on the impact of regulatory changes on clearing broker and futures commission merchant fees and the benefits and costs of netting and compression strategies.  See also “CFTC Issues Guidance for Completing Annual CCO Reports of Swaps and Futures Firms,” The Hedge Fund Law Report, Vol. 8, No. 1 (Jan. 8, 2015).

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  • From Vol. 8 No.7 (Feb. 19, 2015)

    Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations

    The IRS is nudging hedge funds and other market participants toward mark-to-market accounting for many swaps and other derivatives.  Some rules, such as those for Section 1256 contracts, are already in place, while other regulations are in the works.  At a recent presentation, leading tax practitioners offered an overview of the current regime of taxation of swaps and options and insights into how proposed IRS regulations may affect that regime.  See also “Tax Practitioners Discuss Taxation of Swaps, Wash Sales, Constructive Sales, Short Sales and Straddles at FRA/HFBOA Seminar (Part Four of Four),” The Hedge Fund Law Report, Vol. 7, No. 5 (Feb. 6, 2014).

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  • From Vol. 7 No.25 (Jun. 27, 2014)

    Can a Hedge Fund That Holds Senior Subordinated Notes Issued by a Credit Default Swap Seller Sue the Issuer Despite a “No-Action” Clause in the Indenture Governing the Notes?

    The New York Court of Appeals, the state’s highest court, recently ruled on the scope of a “no-action” clause in a bond indenture.  This article analyzes the ruling.  For a discussion of a dispute involving bond redemption rights, see “Recent Decision Highlights the Perils for Hedge Fund Managers of Failing to Understand Early Redemption Provisions in Bond Indentures,” The Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).  For a discussion of a dispute involving an indenture’s impact on bankruptcy claims, see “Tribune Bankruptcy Highlights the Importance of Close Reading of Indenture Agreements by Hedge Funds That Trade Bankruptcy Claims or Distressed Debt,” The Hedge Fund Law Report, Vol. 5, No. 43 (Nov. 15, 2012).

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  • From Vol. 5 No.33 (Aug. 23, 2012)

    Implications of the Second Circuit’s Decision to Reinstate Breach of Contract and Gross Negligence Claims Brought against a CDO Manager

    This article summarizes the events that led to a dispute in federal court relating to a collateralized debt obligation (CDO), a recent Second Circuit opinion in the dispute and the implications of the decision for participants in the CDO market.  This article also summarizes two important practice points arising out of the decision, as identified by Cleary Gottlieb Steen & Hamilton LLP.

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  • From Vol. 5 No.15 (Apr. 12, 2012)

    Recent New York Court Decision Suggests That Hedge Funds Have a Due Diligence Obligation When Entering into Credit Default Swaps

    Domestic and foreign regulators have historically afforded differing levels of protection to retail investors as opposed to sophisticated investors, such as hedge funds, based on their presumptively differing levels of financial knowledge and abilities to conduct due diligence on prospective investments.  Sophisticated investors have been permitted to invest in more complicated financial products based on their presumed ability to understand and conduct due diligence on such investments.  However, the flip side of enhanced access is diminished investor protection, as evidenced by a recent court decision holding that sophisticated investors have a duty to investigate publicly available information in arms-length transactions.

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  • From Vol. 5 No.5 (Feb. 2, 2012)

    Second Circuit Rules Hedge Fund VCG Is Not Entitled to Arbitration in CDS Litigation Because It Was Not a Customer of Wachovia Bank

    On October 28, 2011, the U.S. Court of Appeals for the Second Circuit ruled the investment banking unit of Wachovia NA (Wachovia), Wachovia Capital Markets LLC (WCM), did not have to submit to binding arbitration with VCG Special Opportunities Master Fund Ltd. (VCG).  It reasoned that VCG, the hedge fund suing Wachovia over a $9 million credit default swap (CDS), did not constitute a “customer” of the unit.  For additional background, see “S.D.N.Y. Dismisses Jersey Hedge Fund VCG’s Claim against Wachovia Alleging Improper Demands for Collateral under a Credit Default Swap and Orders VCG to Pay Wachovia Balance of Demanded Collateral and Attorney’s Fees,” The Hedge Fund Law Report, Vol. 3, No. 34 (Aug. 27, 2010), “Hedge Fund VCG Special Opportunities Fund Loses CDS Dispute with Citigroup Unit,” The Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010); “Growing Wave of Credit Default Swap Litigation: Judge Rules Citigroup Did Not Cheat VCG Hedge Fund on Swap and Trims Claims in VCG/Wachovia Litigation,” The Hedge Fund Law Report, Vol. 2, No. 31 (Aug. 5, 2009).

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  • From Vol. 4 No.15 (May 6, 2011)

    Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act

    On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), heralded as the most significant new financial regulation since the Great Depression.  Title II of the Dodd-Frank Act creates a framework to prevent the potential meltdown of systemically important U.S. financial businesses.  This framework includes a new federal receivership procedure, the so-called orderly liquidation authority (“OLA”), for significant, interconnected non-bank financial companies whose unmanaged collapse could jeopardize the national economy.  The OLA will form part of a new regulatory framework intended to improve economic stability, mitigate systemic risk, and end the practice of taxpayer-financed “bailouts.”  The OLA generally is modeled on the Federal Deposit Insurance Act (“FDIA”), which deals with insured bank insolvencies, and also borrows from the Bankruptcy Code.  Notwithstanding the enactment of Title II, there will be a heavy presumption that companies that otherwise qualify for protection under the Bankruptcy Code will be reorganized or liquidated through a traditional bankruptcy case.  If, however, an institution is deemed to warrant the special procedures under the OLA, Title II will apply, even if a bankruptcy case is then pending for such institution.  As discussed in this article, the decision of whether to invoke Title II will be made outside the public view.  As a result, hedge funds that have claims and other exposures to financial companies may find the playing field shifting overnight from the relatively predictable confines of the Bankruptcy Code to the novel and untested framework of the OLA.  In a guest article, Solomon J. Noh, a Senior Associate in the Bankruptcy & Reorganization Group at Shearman & Sterling LLP, provides a high-level discussion of how the following types of claims and exposures would be handled in a receivership governed by Title II based on the regulatory rules currently proposed or in effect: (i) secured claims; (ii) general unsecured claims (such as a claim arising out of unsecured bond debt); (iii) contingent claims (such as a claim relating to a guaranty); (iv) revolving lines of credit and other open commitments to fund; and (v) “qualified financial contracts” (i.e., swap agreements, forward contracts, commodity contracts, securities contracts and repurchase agreements).  Hedge funds employing a variety of strategies – notably, but not exclusively, distressed debt – routinely acquire the foregoing categories of claims and exposures.  For situations in which those claims or exposures face a firm that may be designated as systemically important, this article highlights the principal legal considerations that will inform any investment decision.

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  • From Vol. 4 No.15 (May 6, 2011)

    European Asset Manager Seeks Recovery from LIBOR Panel Banks for Hedge Funds That Lost Income on LIBOR-Based Derivative Contracts

    In a putative class action complaint filed in the U.S. District Court for the Southern District of New York on April 15, 2011, a European asset manager, FTC Capital GMBH, and two of its futures funds, FTC Futures Fund SICAV and FTC Futures Fund PCC Ltd., accused twelve banks of colluding to manipulate the London interbank offered rate (LIBOR) from 2006 to June 2009.  LIBOR generally is the published average of rates at which selected banks (including the defendants) lend to one another in the London wholesale money market.  LIBOR is a global benchmark lenders use to set short-term and adjustable interest rates for almost $350 trillion in financial contracts.  These contracts include those heavily utilized by hedge funds, such as “fixed income futures, options, swaps and other derivative products” traded on the Chicago Mercantile Exchange (CME) and over-the-counter (OTC).  If understated, as alleged in the complaint, LIBOR provides a discount to borrowers, and can cause significant losses to hedge funds that utilize LIBOR-related financial instruments.  This article explains what LIBOR is and how it is used in derivatives contracts, summarizes the material allegations in the complaint and discusses relevant reports in the business press about potential manipulation of LIBOR.

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  • From Vol. 3 No.34 (Aug. 27, 2010)

    S.D.N.Y. Dismisses Jersey Hedge Fund VCG’s Claim against Wachovia Alleging Improper Demands for Collateral under a Credit Default Swap and Orders VCG to Pay Wachovia Balance of Demanded Collateral and Attorney's Fees

    On August 16, 2010, Wachovia Bank, N.A. won dismissal of the final count of a multiple-count lawsuit brought against it by a Jersey hedge fund that accused the bank of breaching its covenant of good faith and fair dealing by demanding more collateral than the $10 million value of a credit default swap entered into between the hedge fund and bank.  In addition to dismissing the case against Wachovia, the U.S. District Court for the Southern District of New York ordered the hedge fund to pay the bank the outstanding balance owed plus legal fees, in an amount to be determined.  This article discusses the factual background of the case and the court’s legal analysis.  For additional background, see “Hedge Fund VCG Special Opportunities Fund Loses CDS Dispute with Citigroup Unit,” The Hedge Fund Law Report, Vol. 3, No. 12 (Mar. 25, 2010); “Growing Wave of Credit Default Swap Litigation: Judge Rules Citigroup Did Not Cheat VCG Hedge Fund on Swap and Trims Claims in VCG/Wachovia Litigation,” The Hedge Fund Law Report, Vol. 2, No. 31 (Aug. 5, 2009).

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  • From Vol. 3 No.27 (Jul. 8, 2010)

    After Bench Trial of First-Ever Credit Default Swap Insider Trading Action, U.S. District Court Rules that Swaps Referencing Bonds Are “Securities-Based Swap Agreements” Under Antifraud Provisions of Securities Exchange Act, but Holds that SEC Failed to Prove Insider Trading

    The Securities and Exchange Commission (SEC) has succeeded in bringing credit default swaps under its jurisdiction over insider trading, but has lost its securities fraud suit against Jon-Paul Rorech (Rorech), a Deutsche Bank bond and credit default swap salesman, and Renato Negrin (Negrin), a portfolio manager employed during the relevant period by hedge fund manager Millennium Partners, L.P.  The SEC had alleged that Rorech and Negrin engaged in insider trading of the credit default swaps of VNU N.V. (VNU), a Dutch media conglomerate.  Rorech allegedly revealed to Negrin non-public information about a proposed bond offering by VNU that would result in an immediate increase in the value of certain credit default swaps that referenced VNU bonds.  As a result of that disclosure, Negrin allegedly purchased VNU credit default swaps shortly before the bond offering was announced and made a substantial profit when the value of those swaps increased following the announcement of the proposed offering.  The District Court determined that, while the SEC did have the power to prosecute its insider trading claims arising out of trading in the VNU credit default swaps, the SEC failed to prove that Rorech revealed material non-public information to Negrin.  We offer a comprehensive summary of the factual findings and legal reasoning in the court’s 122-page opinion.

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  • From Vol. 2 No.51 (Dec. 23, 2009)

    SEC’s First-Ever Credit Default Swap Insider Trading Case Survives Motion to Dismiss

    On May 5, 2009, the Securities and Exchange Commission (SEC) commenced an insider trading enforcement action against Jon-Paul Rorech, a Deutsche Bank bond and credit default swap salesman during the relevant period, and Renato Negrin, a portfolio manager employed during the relevant period by hedge fund adviser Millennium Partners, L.P.  This case is the first insider trading case the SEC has brought with respect to credit default swaps, which are not registered securities.  The SEC alleged that Rorech and Negrin engaged in insider trading of the credit default swaps of VNU N.V., a Dutch media conglomerate.  The defendants moved to dismiss the complaint primarily on the basis that credit default swaps were not “securities based swap agreements” for purposes of insider trading law.  Rorech also argued that the relevant information was not confidential and that the SEC lacked jurisdiction over foreign bonds.  The court rejected their contentions and allowed the SEC’s case to proceed.  We review the arguments made and the court’s rationale for its decision.  See also “SEC Brings First-Ever Credit Default Swaps Insider Trading Case,” The Hedge Fund Law Report, Vol. 2, No. 19 (May 13, 2009).

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  • From Vol. 2 No.31 (Aug. 5, 2009)

    Growing Wave of Credit Default Swap Litigation: Judge Rules Citigroup Did Not Cheat VCG Hedge Fund on Swap and Trims Claims in VCG/Wachovia Litigation

    In a pair of recent lawsuits in the United States District Court for the Southern District of New York, VCG Special Opportunities Master Fund, Ltd. (VCG or CDO Plus), an Isle of Jersey, U.K.-registered hedge fund of approximately $50 million in assets and a credit default swaps (CDS) seller previously known as “CDO Plus Master Fund Ltd.,” sued Citibank, N.A. and Wachovia Bank, N.A., both CDS buyers, raising similar claims against each bank.  VCG alleged that both banks had purchased CDS contracts from VCG, each covering a different credit default obligation for the amount of $10 million, and that each had made unwarranted and bad faith demands for additional credit support, i.e., margin calls.  These lawsuits are part of a growing wave of credit default swap litigation and highlight the need for caution in this area.

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  • From Vol. 2 No.28 (Jul. 16, 2009)

    In FINRA’s First Action Involving Credit Default Swaps, FINRA Fines ICAP $2.8 Million to Settle Price Fixing Claims

    ICAP Corporates LLC (ICAP), a unit of ICAP Plc, one of the largest brokers of inter-bank transactions, has settled with the Financial Industry Regulatory Authority (FINRA) over allegations that a former broker improperly influenced fees on credit-default swaps (CDS).  Specifically, FINRA accused a former broker and manager of the ICAP CDS desk, Jennifer Joan James, of “improper communications” with competing firms about customers’ proposed brokerage rate reductions in the wholesale credit default swap market.  We detail FINRA’s allegations and the specifics of the settlement.

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  • From Vol. 2 No.22 (Jun. 3, 2009)

    Proposed Model Act Would Severely Undermine Participation by Hedge Funds as Sellers of Protection Under Credit Default Swaps

    The National Conference of Insurance Legislators is circulating a draft of a model act (Model Act) that would have the adopting states regulate credit default swaps under provisions patterned on New York State’s current regulation of financial guaranty insurance.  The Model Act would provide that “credit default insurance may be transacted in this state only by a corporation licensed for such a purpose,” and it imposes a variety of requirements upon the licensees.  This article reviews the draft, analyzes how it would operate and then discusses the conflict between an approach to regulation that would empower the insurance departments of 50 states and one that would employ a single regulatory policy.

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  • From Vol. 2 No.19 (May 13, 2009)

    SEC Brings First-Ever Credit Default Swaps Insider Trading Case

    On May 5, 2009, the Securities and Exchange Commission (SEC) charged Jon-Paul Rorech, a salesman at Deutsche Bank Securities, and Renato Negrin, a former Millennium Partners, L.P. hedge fund portfolio manager with insider trading in credit default swaps of VNU N.V., a Dutch media conglomerate (VNU).  According to the SEC, this case is the first insider trading enforcement action it has brought with respect to credit default swaps (CDSs).  Rorech allegedly learned information from Deutsche Bank investment bankers about a change to a proposed VNU bond offering that was expected to increase the price of CDSs on VNU bonds.  Rorech then purportedly illegally tipped Negrin about the contemplated change.  Negrin then purchased CDSs (which are not registered securities, and are used to insure against the default of debt and certain related credit events) on VNU for a Millennium hedge fund.  According to the SEC, when news of the restructured bond offering became public in late July 2006, the price of VNY credit default swaps increased, and Negrin closed Millennium’s VNU credit default position at a profit of about $1.2 million.  The SEC seeks an injunction barring further securities laws violations, disgorgement of profits and civil penalties.  We detail the SEC’s factual allegations and legal claims.

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  • From Vol. 2 No.13 (Apr. 2, 2009)

    FINRA Proposes Interim Pilot Program for Margining Credit Default Swaps

    On March 18, 2009, the Financial Industry Regulatory Authority (FINRA) announced its proposal to the Securities and Exchange Commission for a pilot program to impose margin rules for credit default swaps transactions executed by a FINRA-registered broker-dealer and cleared by the Chicago Mercantile Exchange (CME) or other central counterparty platforms.  The new rule would apply to transactions executed by a member, regardless of the type of account in which the transaction is booked, and include transactions in which the member cleared offsetting matching hedging transactions through the central counterparty clearing services of the CME.  We offer a comprehensive summary of FINRA’s proposal.

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  • From Vol. 1 No.27 (Dec. 9, 2008)

    Regulating Credit Default Swaps as Insurance: Gone, But Not Forgotten

    Although New York State Insurance Superintendent Eric R. Dinallo decided to “delay indefinitely” his plan to regulate an important chunk of the credit default swaps (CDS) market as insurance contracts, the agency’s original policy proposal may well be used as a blueprint in wider efforts by federal regulators to reform the CDS market.  We explain the mechanics of the proposal and detail provisions that may reappear in future legislation or regulation.

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  • From Vol. 1 No.14 (Jun. 19, 2008)

    Federal District Court Invalidates Purported Terminations of Credit Default Swaps by Bond Insurer

    On June 11, 2008, in a one-page order, the US District Court for the Southern District of New York ruled that Merrill Lynch International did not repudiate its obligations under seven credit default swaps with affiliates of bond insurer XL Capital Assurance Inc. with a notional value of $3.1 billion, and that XL’s purported terminations of those credit default swaps were without effect.

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  • From Vol. 1 No.13 (May 30, 2008)

    Do Credit Default Swaps Need to Be Regulated as Insurance?

    The New York State Insurance Superintendent suggested in an interview that short positions in credit default swaps may be ripe for regulation as insurance, but the views of industry participants and other commentators are sharply divided.

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  • From Vol. 1 No.11 (May 13, 2008)

    New York Insurance Regulator Suggests that “Core” Credit Default Swaps Might be Ripe for Regulation as Insurance Contracts

    Eric Dinallo, the New York insurance superintendent, indicated in an interview that credit default swaps in which the protection buyer owns the underlying asset may constitute insurance arrangements, under statutory definitions, and perhaps should be regulated as such.

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  • From Vol. 1 No.4 (Mar. 24, 2008)

    Counterparty Risk in Credit Default Swaps: What Happens when a Broker-dealer Goes Bust?

    • Barclays predicts $80 billion in losses from counterparty CDS defaults in 2008.
    • Bankruptcy code exempts swaps and repos from the automatic stay, giving hedge funds accelerated right to terminate under swap agreements.
    • When selling CDS to a broker-dealer, hedge funds must post up-front collateral and supply additional payments if the reference asset declines in value.
    • Amount and timing of recoverable collateral depends whether broker-dealer liquidates under Chapter 7 or under SIPA.
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  • From Vol. 1 No.2 (Mar. 11, 2008)

    Hedge fund sues Wachovia and Citibank alleging the banks demanded excessive collateral in connection with credit default swaps based on collateralized debt obligations

    • A $50 million hedge fund sued (separately) Wachovia and Citibank, alleging that the banks demanded excessive collateral in connection with credit default swaps based on collateralized debt obligations.
    • In the Wachovia matter, the fund relied on the confirmation letter for its claim that the bank did not have the right to demand as much collateral as it did, while Wachovia relied on the ISDA Credit Support Annex in support of its right to demand the collateral.
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