Wall Street banks and hedge funds are closing in on a fix that they hope will clean up an $8 trillion portion of the derivatives market that’s gained a reputation for being one of the shadiest corners in finance.
At issue are a number of transactions in recent years in which powerful investment firms have been accused of earning big money from swaps trades by enticing companies to miss bond payments they could otherwise make. The practice has eroded market confidence, triggered legal fights and led to scrutiny from regulators.
After months of negotiations, titans including Goldman Sachs Group Inc., JPMorgan Chase & Co., Apollo Global Management and Ares Capital Corp. have agreed to a plan that’s intended to ensure that defaults are tied to legitimate financial stress, not traders’ derivatives bets, said three people familiar with the matter.
An industry trade group, the International Swaps and Derivatives Association, will likely propose the overhaul this week, said two of the people who asked not to be named because the changes haven’t been released publicly. The revamp would affect credit-default swaps, instruments that contributed to the 2008 financial crisis that insure against a bond issuer’s bankruptcy or failure to pay.
“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."
Tipping Point
A trade widely seen as a tipping point occurred last year when Blackstone Group LP’s GSO Capital Partners encouraged homebuilder Hovnanian Enterprises Inc. to skip an interest payment in return for a sweetheart loan. Firms that were at risk of losing money protested because they had sold CDS insuring against a missed payment. One hedge fund even sued GSO, which ultimately agreed to unwind its trade.
ISDA’s decision to try to clamp down is a recognition that so-called manufactured defaults might be deterring some investors from entering the market. In addition, 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.
As soon as Wednesday, the group will propose adding language to a broad set of protocols that CDS agreements around the world are based on, the people said. The new terms will lay out that a company’s failure to make a bond payment must be tied to its credit worthiness. While the changes are voluntary and lack the teeth of regulations, firms that refuse to sign on could have trouble finding trading partners.
The overhaul could be finalized in the next few months. It would apply to new CDS contracts, and existing agreements could also be amended.