|After "Irreparable Damage" Warnings, Wall Street Finally Cracks Down On CDS Manipulation by Tyler Durden Tue, 03/05/2019 zero hedge |
Wonderful: “Meanwhile, regulators have also barged in, and confirming that an official crackdown on the CDS market may be imminent, the CFTC warned last April that “manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets.”
Goodness..... Who knew?
Last January, after several perplexing instances when credit default swaps mysteriously traded in precisely the opposite direction of where they were supposed to, derivatives traders finally "cried foul" over the Blackstone-led refinancing deal for US housebuilder Hovnanian, saying what they had just observed threatened to further undermine the shrinking market for credit default swaps.
So what happened? Well, heading into the end of 2017, the credit derivatives swaps of Hovnanian were soaring as if New Jersey’s largest homebuilder was about to default, even as its stocks and bonds show no signs of panic.
As it subsequently turned out, the catalyst behind this divergence was a bizarre battle raging among hedge funds, with one group saying that the other has offered Hovnanian financing in return for taking steps that would trigger payouts on those derivatives. The claim came in a letter from law firm White & Case, which said it’s been made aware of a proposal in which Hovnanian would pursue a refinancing deal with the main intention of triggering a credit event that would lead to a payout on the credit-default swaps.
At the time, Bloomberg identified the main actors as hedge fund Solus Alternative Asset Management, which owned both Hovnanian’s bonds and sold CDS guaranteeing the company won’t miss a debt payment, while its counterparty was Blackstone’s GSO Capital partners hedge fund, an investor with which Hovnanian has explored a restructuring that would trigger a CDS payout.
What makes the deal unique, is that in order to secure the funds from GSO, Hovnanian had agreed to skip a payment on some of its existing bonds, triggering a technical default and a big payday for the hedge fund, which unlike Solus, was long Hovnanian CDS.
As we then explained last May, this particular fiasco in the CDS market was hardly isolated, but it served to demonstrate how any human system - when enough money is at stake - will eventually be gamed beyond its breaking point.
Furthermore, while legal, traders said the arrangement made a mockery of a market designed to be used to hedge the risk of real defaults at companies in genuine financial distress. Furthermore, while the tactic of making refinancing conditional on triggering CDS had been used on various occasions before, the Hovnanian situation was unusual because of the size of the deal and because the company was not in financial distress.
Finally, as one would expect, the most vocal opponent of the scheme was Solus, which claimed that the "illegal" scheme could cost it and other sellers of Hovnanian credit default swaps hundreds of millions of dollars.
And just to underscore the above point, Solus also stated that "the integrity of the CDS market - which is predicated on the expectation that companies seek to avoid payment default, not to accept illicit payments to default intentionally - will be irreparably damaged," Solus said (for a recap of all "bizarre" CDS deals, read our primer on Orphan CDS and manufactured credit events from last May).
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Fast forward to today, when in an attempt to finally reverse the "irreparable damage" to the CDS market, Wall Street banks and hedge funds were set to implement a fix that would finally clean up the $8 trillion CDS market that had gained a reputation for being one of the shadiest corners in finance.
As Bloomberg reports, after months of negotiations, CDS market titans such as Goldman Sachs, JPMorgan, Apollo Global and Ares Capital have agreed to a plan that’s intended to ensure defaults are tied to legitimate financial stress, not traders’ derivatives bets, and as a result, the infamous International Swaps and Derivatives Association, or ISDA (which several years ago made a mockery of CDS as hedges for sovereign defaults as pertains to the case of Greece, but that's another story) is likely to propose the overhaul as soon as Wednesday.
The proposed fix, however, far from a "silver bullet" will be limited to just "manufactured default" deals - the kind we profiled one year ago - and it remains unclear whether it will bolster confidence in the broader CDS market.
“There have been concerns that narrowly tailored credit events negatively impact the efficiency, reliability and fairness of the overall CDS market,” Jonathan Martin, director in market infrastructure and technology at ISDA, said in a statement. “We hope these proposed changes will address that.”
So what will the proposed change entail? Simply stated, it will force events of default to be linked to actual underlying creditworthiness (or lack thereof), instead of events of default prearranged in some dark alley between a corporate CFO and some billionaire hedge fund manager.
Additionally, the changes will be non-binding, voluntary and unenforceable.
However while the overhaul will be voluntary, firms that refuse to sign on could have trouble finding trading partners. Additionally, while the overhaul could be completed in the next few months, but full implementation could take much longer, effectively allowing a long-enough window for many more Hovnanian-type manufactured defaults to emerge in the coming months. If the proposal passes, the new standards would apply to new CDS contracts, and existing agreements could also be amended. Still, it’s unclear whether the coming directive will capture all the creative ways that firms have structured CDS trades to make money.
Yet while the proposal may be toothless for now, ISDA’s decision to clamp down is a recognition that manufactured defaults might be deterring some investors from entering the market. In addition, as Bloomberg notes, the industry wants to show global regulators it can address the problem on its own to stave off stiff rules and beefed-up government oversight.
“People had become gun shy about using the CDS product to invest in and manage credit risk,” said John Williams, a law partner at Milbank who represents buyside firms active in the CDS market including Apollo and Ares. “This is a very serious effort to make the rules fair.”
Ironically, in the wake of the Hovnanian controversy, GSO founder Bennett Goodman - who in 2017 was eager to take advantage of the loopholes in the CDS market is now actively petitioning to clean it up - said that Blackstone would back revamping the standards that govern CDS trades. And while Blackstone wasn’t formally part of the group that reached the preliminary agreement, one of the people said, but there is no indication it will oppose the plan.
Meanwhile, regulators have also barged in, and confirming that an official crackdown on the CDS market may be imminent, the CFTC warned last April that “manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets.”
That said, CFTC chairman, Christopher Giancarlo has offered the industry to solve its issues on its own, and said that he hoped ISDA would resolve the matter with market participants. Meanwhile, U.K. Financial Conduct Authority CEO Andrew Bailey said in July that “this is a practice that’s the wrong side of the line.”
Meanwhile, until a solution is found, the tensions in the market will remain, and as Milbank's John Williams said, “when the rules can be manipulated it’s very painful to be the second-smartest guy on the street"; of course since he also represents Blue Mountain Capital Management, CQS and Brigade Capital Management, his clients tend to be the ones who do the manipulation and end up with the profits.
And, as we said last May, even if a "fix" is implemented, any human system - when enough money is at stake - will eventually be gamed beyond its breaking point. As such, when a market is dominated by a handful of bloodthirsty hedge funds and nobody else as the CDS market has become over the past decade, it is only a matter of time before whatever fix ISDA implemented in the coming days is quietly violated by the next "smartest-guy on the street."