Northern Black Tailed Rattlesnake by GustavoG (flickr)Martha Stewart went to jail for insider trading in stocks. She should have been trading credit default swaps, where it’s pretty close to legal. Last May, the SEC filed a civil insider trading case based on trades in credit default swaps (for a refresher, see below). The amazing thing is that the defendants may have a good defense that there isn’t any law allowing the SEC to enforce securities laws against them. That is just another consequence of the Gramm-Leach-Bliley Act, the law that got rid of Glass-Steagall. It also barred the SEC from gathering information about CDSs. They trade in the shadows, which is exactly what the banksters wanted.

There is one tiny hole for regulation: the Securities and Exchange Commission can enforce the antifraud provisions of the Securities Exchange Act of 1934 with respect to “security-based swap agreements”. The most important antifraud provision is Rule 10b-5, which establishes a broad and open-ended prohibition on all kinds of securities fraud, including insider trading.

In this case, the CDSs protected the debt of VNU, a Dutch company that went private in May 2006, and announced a restructuring of its debt in July. The idea was to issue new bonds from the subsidiaries of VNU. There were CDSs on the VNU bonds, but they would not cover the debt of the subs. An investment banking subsidiary of Deutsche Bank was handling the restructuring, and was concerned about this issue. One solution was for VNU to issue a new layer of bonds which would be covered by the existing CDSs.

One factor affecting the price of CDSs referencing the VNU bonds in July 2006 was the limited supply of bonds covered by (or, “deliverable into”) those CDSs. An increase in the supply of VNU bonds deliverable into CDSs would result in an increase in exposure and demand for CDSs covering the default of such bonds and, therefore, an increase in the market price for CDSs referencing those bonds.

Complaint, para. 14. Deutsche Bank’s employee Rorech tipped off a hedge fund guy named Negrin about the new idea. Armed with that confidential information, Negrin bought a bunch of the VNU CDSs. When the new structure was announced, Negrin sold the CDSs and made $1.2mm.

It’s hard to care about this case. The only people who trade CDSs are huge banks, brokers, hedge funds and other giants. Insider trading in CDSs only hurts the financial elites. If a rattlesnake is fighting a skunk, who cares who wins or loses? Maybe they’ll kill each other, and there will be two fewer varmints.

Studies show evidence of insider trading. From the abstract of one:

Using news reflected in the stock market as a benchmark for public information, we report evidence of significant incremental information revelation in the credit default swap (CDS) market under circumstances consistent with the use of non-public information by informed banks. Specifically, the information revelation occurs only for negative credit news and for entities that subsequently experience adverse shocks. Moreover the degree of advance information revelation increases with the number of banks that have lending/monitoring relations with a given firm, and this effect is robust to controls for non-informational trade.

It’s circumstantial evidence, but what other kind is available if regulators can’t gather information about trading in CDSs? And if you can’t detect insider trading, how is that different from making it legal?

To establish its right to sue, the SEC has to show that the VNU CDSs are “security-based swap agreements.” The defendants moved to dismiss on the ground that the CDSs aren’t security-based. VNU is a Dutch company, so the question is whether the foreign securities are securities subject to SEC authority. There are also questions about US jurisdiction because of the international aspects of the trades. The trial court denied the motion to dismiss on these and related grounds, but allows the defendants to put on evidence at trial to prove that the SEC has no jurisdiction.

The bond availability issue demonstrates a strange interaction created by the existence of CDSs. Deutsche Bank thought that the proper structure was bonds of subsidiaries, but because of CDSs, it had to move to a different structure, instead. That may or may not be a good thing, but it shows the impact of CDSs on the real productive world.

One thing the case makes clear is that trading in “non-security-based swaps” is the free market, with no regulation or liability. That probably includes interest rate and commodity swaps. There, insider trading is perfectly legal.

May the best rattlesnake win.
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To review, a CDS is insurance on bonds or other debt. One party, the protection seller, agrees to pay the other, the protection buyer, the amount of any loss that occurs if the debt doesn’t get paid. The buyer agrees to pay a fee with the contract, and regular payments. For those interested, Wikipedia has a good description. The CDS is a contract, almost always on standard terms established by the International Swaps and Derivatives Association.

Northern Black Tailed Rattlesnake detail by GustavoG