Looming large as a backdrop to Wall Street's turmoil is an unregulated Goliath of a market with an immensity that tests the limits of imagination. In recent statements, congressional testimony and commentary, Securities & Exchange Commission Chairman Christopher Cox has called attention to the dangers of unsupervised trade in the Credit-Default Swap(CDS).
On September 26, Cox announced a decision by the Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program. The program was created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation.
Cox said the agency would enhance its oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on a recent Memorandum of Understanding between the SEC and the Fed.
In a press release, Cox said, "The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC, or any agency, the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns."
Cox said that because the Commission lacked explicit statutory authority to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, it created the voluntary CSE program in an effort to fill this regulatory gap.
"As I have reported to the Congress multiple times in recent months," he said, "the CSE program was fundamentally flawed from the beginning because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness."
Three days earlier, on Sept. 23, Cox had raised an even more sobering alarm in testimony before the Senate Committee on Banking, Housing, and Urban Affairs: "The failure of the Gramm-Leach-Bliley Act to give regulatory authority over investment bank holding companies to any agency of government was, based on the experience of the last several months, a costly mistake. There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion national market in credit-default swaps - - double the amount outstanding in 2006 - - is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market. This is an area that our Enforcement Division is focused on using our anti-fraud authority, even though swaps are not defined as securities, because of concerns that CDS offers outsized incentives to market participants to see an issuer referenced in a CDS default or experience another credit event."
According to Cox, the estimated market value of credit default swaps is (hold onto your seat) "more than the gross domestic product of all nations on earth combined."
"Yet despite its enormous size, the credit-default swaps market has operated in the shadows," he commented in an OpEd penned for the New York Times. "There is no public disclosure nor any legal requirement for these contracts to be reported to the Securities and Exchange Commission or any other agency. So government regulators have had no way to assess how much risk is in the system, whether credit-default swaps have been accurately valued or honestly traded, and when people issuing and trading them have taken on risk that threatens others."
Cox wrote that credit-default swaps have been marketed widely and often anonymously and have "trapped large financial institutions in a web of transactions. This," he continued, "created systemic risk that is particularly serious in the current stressful economic environment, contributing to a gravitational pull that stands to drag everyone down."
Credit-default swaps, the SEC chief said, "are not inherently good or evil" but markets function best "when they are highly transparent, when everyone can see exactly which transactions are occurring and what the instruments being traded are worth."
Arguing for greater transparency, Cox asserted that "When investors have clear and accurate information, and when they can make informed decisions about where to put their resources, money and credit will begin to flow again. By giving regulators the authority they need to bring the credit derivatives market into the sunshine, we can take a giant step forward in protecting our financial system and the well-being of every American.