Written Statement of Managed Funds Association. Standing Committee on Insurance New York State Assembly

Transcription

1 Written Statement of Managed Funds Association Standing Committee on Insurance New York State Assembly Hearing Regarding the State s Regulation of the Credit Default Swaps Market December 5, 2008 Submitted: December 19, Introduction Managed Funds Association ( MFA ) is pleased to provide the following written statement in connection with the hearing of the Standing Committee on Insurance (the Committee ) of the New York Assembly regarding the State s regulation of the credit default swaps ( CDS ) market held on December 5, 2008 (the Hearing ). MFA appreciates the leadership demonstrated by the Committee and the New York State Insurance Department (the Department ) in addressing these timely and important issues surrounding the CDS market. MFA is the voice of the global alternative investment industry. Its members are professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. Established in 1991, MFA is the primary source of information for policy makers and the media and the leading advocate for sound business practices and industry growth. MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies. MFA is headquartered in Washington, D.C., with an office in New York, NY. 2. Importance of the CDS Market There are several ways in which the broader financial system and New York have benefited from increased trading in the CDS market. In particular, CDS trading has increased the ability of banks and other lenders to extend more credit to borrowers and businesses inside and outside of New York. Over the last ten years, CDS have become a critical means by which investment managers manage the risk and returns of the assets in their portfolios in order to meet the objectives of their investors. The CDS market has grown in part because credit derivatives permit dispersion and realignment of credit risks. As a result of this dispersion and realignment, banks and other lenders have been able to engage in greater lending and corporate finance activity.

2 2 In addition, the growth of the CDS market has created new jobs and innovative technologies based in New York. As a result of this growth, New York has seen an increase in its revenue base. 3. MFA s Involvement in Improving CDS Market Practices The CDS market is of great importance to MFA members as many of the funds they manage are active investors in CDS. As a result, MFA has consistently supported and participated in improving market practices and reducing systemic risk that may be associated with the trading of CDS through collaboration with federal regulators, the major derivatives dealers and other market participants. Specifically, MFA and several of its members are active participants in an industry leadership group of operations professionals called the Operations Management Group ( OMG ), whose mission is to: (1) examine the current front-to-back processes for CDS and other over-the-counter ( OTC ) derivatives, and (2) lead an effort to strengthen those processes by the establishment of industry commitments. Established in the fall of 2005, the OMG has developed industry standards in collaboration with U.S. and non.-u.s. industry regulators (including the Federal Reserve Bank of New York, the U.S. Securities and Exchange Commission and the U.K. Financial Services Authority) to strengthen operational efficiency and thereby reduce risk in the global markets for CDS and other OTC derivatives. In addition, MFA and its members have also participated in a number industry initiatives organized by the International Swaps and Derivatives Association ( ISDA ). These initiatives focus on standardizing the transaction documentation and industry practices related to CDS trading. In support of these initiatives, MFA has organized and sponsored several seminars and meetings for its members in order to promote the objectives and standards that the industry seeks to achieve in the processing of OTC derivatives. MFA continues to educate its members and promote investment in technology infrastructure that will permit market participants to achieve significant advances in the operational efficiency of the CDS market. 4. Federal versus State Oversight of the CDS Market MFA recognizes that the State and its regulatory agencies have the authority to regulate entities that are established and/or doing business in New York to the extent that State regulation is not preempted by federal law. For example, the New York State Banking Department regulates banks chartered in New York and coordinate regulatory oversight with the Federal Reserve Bank of New York and other federal regulators over the financial activities of those banks. Similarly, New York through the Department appropriately supervises many U.S. financial guaranty insurance companies ( FGIs ) authorized to issue insurance in New York and is authorized to supervise the operation of those FGIs.

3 3 Nonetheless, MFA believes that the CDS market would be more appropriately and effectively supervised by federal policy makers and regulators for two reasons. First, we believe that because federally-regulated banks are the most active market participants in the CDS market, the federal regulatory regime and industry engagement on a federal level would deliver the most effective and consistent means of supervising the CDS market. Department Superintendent Eric Dinallo implicitly agreed with this concern and was quoted as saying [T]he best solution for a healthy market in credit default swaps is a single market. That won't happen if New York regulates some transactions under the insurance law, while the rest of the market is either unregulated or regulated under other laws. 1 Second, the imposition of regulations on a state level would put New York at a competitive disadvantage relative to other financial markets. 5. Unintended Consequences of Circular Letter #19 MFA strongly believes that the Department s Circular Letter #19 issued on September 22, 2008 (the Circular ), if permitted to go into effect on January 1, 2009, would have caused great disruption in financial markets in several respects. While we believe that the Circular provided an outline of potentially useful standards in the limited circumstance of FGIs engaged in the issuance of CDS, the application of the Circular to non-fgi financial institutions would have created several unintended consequences for the CDS market generally and New York in particular. As described below, we believe that, if the Circular went into effect in its proposed form, it would have increased expense and reduced liquidity in the debt market and the broader OTC market, thereby contributing to the credit crisis and driving business out of New York. Although MFA was very supportive of the Department s leadership in addressing the current financial crisis, we were encouraged by the Department s decision to indefinitely delay the application of the Circular. Allowing market participants to use CDS as credit protection provides them with an important means of hedging their exposure to credit risk presented by their counterparties to OTC derivatives trades. The Circular would have made it very difficult for market participants to purchase credit protection against the potential failure of their OTC derivatives counterparties. This prospect would have likely resulted in the reduction of trading activity by market participants in the OTC derivatives market in order to minimize counterparty credit risk, thereby compromising market liquidity. In addition, we believe that the Circular would have created a chilling effect on the credit markets. Institutions would have found it cost-prohibitive to fully or partially hedge the risks presented by their asset-backed securities and other debt holdings by purchasing CDS protection. As a result, corporations and financial institutions would have been less likely to issue new debt (e.g., home mortgages, car loans and corporate debt). 1 New York State Insurance Department News Release, New York Will Stay Plan to Regulate Some Credit Default Swaps, November 20, 2008.

4 Finally, we believe that the Circular would have driven many participants in the CDS market, including hedge funds and other asset managers, out of New York into other jurisdictions that have more favorable laws and regulations. As referenced above, the New York job market and economy have benefited from the CDS market. If market participants were to leave the State, the effect on New York would be significant Public/Private Sector Solutions to Address Risk Concerns MFA believes that the best framework to address market and systemic risk concerns in our capital markets is through principles-based regulatory supervision, industry engagement and cooperation of all market participants. This framework is the lynchpin of the work of the President s Working Group on Financial Markets, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission and the Commodity Futures Trading Commission in collaborating with market participants to establish one or more central counterparty clearing platforms ( CCPs ) for CDS. MFA believes that a supervised CCP can provide immediate benefits to the market by mitigating the systemic risk that may be associated with counterparty credit risk exposures, providing enhanced liquidity and price discovery by means of standardization and centralized trading, and increasing market transparency. MFA and its members have met with each CDS CCP provider to discuss their respective clearing solutions and how each provider plans to account for the various transaction parameters and risks related to CDS trading. In a series of presentations and other communications, each CDS CCP provider demonstrated to MFA and its members that it has established for its CCP solution-specific capitalization requirements, margining methodologies, a guarantee fund, dispute resolution mechanisms and other comprehensive risk and transparency measures. After meeting with the CDS CCP providers, MFA and many of its members have concluded that, with direct federal oversight, one or more CDS CCPs will likely reduce counterparty risk and systemic risk as soon as they commence operations, which is expected to occur as early as January Moreover, MFA believes that coordination of efforts between federal and State regulators, as well as market participants, will further improve the effectiveness of the CCPs. Superintendent Dinallo commented that he is pleased to see that [the Department s] strong stand has encouraged the industry and the federal government to begin developing comprehensive solutions. 2 It is our understanding that the New York Banking Department is working with the Federal Reserve Bank of New York and one of the CDS CCPs to establish a New York trust company to serve as a clearing house for CDS. MFA and its members are supportive of New York s involvement to-date in advancing the establishment of one or more CDS CCPs and of the State s ongoing coordination with federal regulators. 2 Id.

5 7. Conclusion 5 CDS play an important role in our capital markets and to the economy of New York. The growth of the CDS market over the last decade is a testament not only to the innovation and sophistication of our country s financial markets and its participants, but also the flexibility afforded by the regulatory framework under which they operate. MFA believes that public/private sector cooperation is the best solution to meet the challenges presented by the robust growth of the CDS market. The establishment of CCPs to clear CDS will enhance operational efficiency and mitigate the risks associated with investing and trading in CDS. MFA is pleased to offer this written statement in connection with the Hearing and hopes that the views set forth herein are helpful to the Committee in its deliberations. MFA would be pleased to work with the Committee and its staff on any further efforts that it determines to undertake in respect of this important topic.