Per the WSJ, the SEC has decided to bring its first insider trading case involving credit default swaps.
CDS’s have gotten a lot of bad press as a key factor in the financial meltdown. But we should keep in mind that they also have a positive function of providing a public market mechanism for revealing information concerning otherwise closely held securities. Very simply, the price of the swaps depends on the risk of default, as revealed by what traders are willing to pay. Informed traders mean more informed prices.
The SEC claims that a Deutsche Bank salesman gave inside information to a trader who used it to make a $1.2 million profit on CDS’s tied to DB debt. There are a few problems with this case, like the fact that CDS’s themselves aren’t securities, and they relate to European securities that aren’t regulated by the SEC. According to the WSJ, “[t]he SEC said it has jurisdiction because the swaps are "security-based," and the two traders are based in the U.S.”
I haven’t researched these problems, and anyway want to focus on the bigger picture: should the SEC be bothering with this?
I wrote on this almost three years ago, after the WSJ revealed a supposed insider trading scandal in CDS’s. The reporters cited a study by Acharya and Johnson, Insider Trading in Credit Derivatives, which found evidence of insider trading in this market. As I pointed out:
The problem with this story is that this is one of the most sophisticated markets around. The investors trade in $5 million lots. That's not you or me. Surely they know about the risk, and price the securities accordingly. And this provides a research opportunity. If insider trading is a problem (and it probably isn't) it's because it reduces liquidity by increasing the cost of trading because the market makers know they're trading against insiders. The counter is that insider trading makes the market more informed, which can decrease traders' risks and trading costs. So the empirical question is: in a sophisticated market like this, where everybody knows about the big risk of insider trading, does this reduce liquidity?
This is what the Acharya and Johnson article was really about. The authors conclude:
We find no evidence, however, that the degree of asymmetric information adversely affects prices or liquidity in either the equity or credit markets. If anything, with regard to liquidity, the reverse appears to be true.
The authors note that there are a number of possible explanations for the lack of a liquidity effect that warrant further study. But the point is that the really interesting aspect of this paper that the WSJ reporters rely on so heavily is not the scandal that there is insider trading in the credit default swap market, but that insider trading may not be a problem after all.
All of this is still true. Plus the serious question whether the SEC can meaningfully police this market. In order to find a case where they could actually track the information – a big problem in this market – they had to stretch their jurisdiction to swaps relating to European securities.
So the SEC, having dropped the ball on Madoff’s multi-billion dollar fraud, has been trying to restore its reputation by cracking down on the legitimate information-revealing mechanisms of short-selling and hedge funds. Now it’s flown off to Europe to find a miniscule profit that probably hurt nobody.
This is not the way the SEC can prove its value.
Larry, if you haven't seen it yet, here is a recent GAO report on SEC enforcement [and problems therein]--
http://www.gao.gov/cgi-bin/getrpt?GAO-09-358.
Posted by: Ed | May 07, 2009 at 12:59 PM