United States: New York State Insurance Department Tables Plan To Regulate Credit Default Swaps

Originally published November 21, 2008

One of the most controversial proposals for regulating the derivatives market may have come to an end with yesterday's announcement by New York State Insurance Department Superintendent Eric Dinallo that his department would delay indefinitely its plan to regulate covered credit default swaps ("CDS"). In a letter circulated to authorized financial guaranty insurers, Mr. Dinallo stated that recent progress by the President's Working Group on Financial Markets on comprehensive federal regulation of CDS led his department to table its plan. For Mr. Dinallo's letter, please click here.

An intense debate has raged throughout the derivatives and broader financial communities in response to Mr. Dinallo's announcement on September 22, 2008, that New York would begin regulating covered CDS in January 2009. New York's plan was limited to the regulation of so-called "covered" CDS, or CDS in which the swap buyer owns the underlying obligations being protected. The New York State Insurance Department claimed authority to regulate covered CDS by characterizing these contracts as insurance purchased by the swap buyer.

New York's plan was immediately criticized by both derivatives end-users and dealers who argued that the plan could lead to regulatory uncertainty since it failed to address "naked" CDS contracts in which the underlying obligations referenced by a swap are not owned by its purchaser. In discussing yesterday's announcement before the U.S. House of Representatives Committee on Agriculture, Mr. Dinallo gave credence to those who questioned the viability of a plan addressing only covered CDS by acknowledging that, "the best route to a healthy market in credit default swaps is not to divide it up among regulators."

As Mr. Dinallo noted in yesterday's letter, the President's Working Group on Financial Markets announced a wide-ranging set of initiatives on November 14, 2008, aimed at providing more universal regulation of the derivatives market.¹ These initiatives are designed to shore up the over-the-counter derivatives market—including CDS—through increased oversight and transparency, and the creation of a central counterparty (e.g., a clearing house or exchange) for trading of CDS.²

While recognizing the efforts of the President's Working Group on Financial Markets to develop a comprehensive approach to derivatives regulation, Mr. Dinallo did not foreclose the possibility that the New York State Insurance Department might take future actions to regulate CDS as insurance, stating: "We understand that the market for credit default swaps is large and complex and it will take time to complete a holistic solution. But while we support these beginning efforts, we also recognize that they do not yet constitute a completely transparent and fully regulated market. We urge the industry, federal agencies and Congress to continue working until that essential goal is reached. At that point, we will be prepared to consider any necessary changes in state law to prevent problems that might arise from the fact that some swaps are insurance."

At least one member of Congress has heeded Mr. Dinallo's call to action. Sen. Susan Collins (R-Maine) announced the introduction of the "Financial Regulation Reform Act of 2008" on November 18, 2008, which would establish regulation for investment-bank holding companies and institute reporting requirements for CDS.³

We will continue to follow potential regulatory changes affecting derivatives products at both the federal and state levels, and will keep you informed of all relevant developments.

Footnotes

^{1 See Sutherland's Legal Alert entitled, President's Working Group Announces Initiatives to Strengthen OTC Derivatives Oversight and Infrastructure, please click here.}

^{2 Several proposals for exchange-like platforms are in the works, including one proposed by the Chicago Mercantile Exchange and Citadel (see Electronic Platform for CDS Is Proposed, THE WALL STREET JOURNAL, October 7, 2008) and another proposed by The Clearing Corp. working with the Depository Trust & Clearing Corporation (see CDS Clearing House Nears Launch, DERIVATIVES WEEK, August 18, 2008, at 6).}

^{3 See Collins Introduces Bill Seeking Regulation of CDSs, Investment-Bank Holding Companies, REGULATORY REFORM, November 19, 2008.}

© 2008 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.