The internationally respected Network for Sustainable Financial Markets has just released a blueprint for fundamental changes to the Credit Derivatives market. The Network suggests that proposed changes will bring fairness and sustainability to what has been a dangerously opaque and, as a result, mispriced sector of the financial system.

Prepared by corporate governance and insolvency expert Dr. Janis Sarra, of the University of British Columbia Faculty of Law, and endorsed by respected investment professionals and academics who are members of NSFM, the paper recommends 10 immediate systemic changes to create targeted and effective regulatory oversight of the credit derivatives markets.

Presenting the paper on Monday in Washington D.C. to a joint Task Force of the World Bank and the International Monetary Fund on the current financial crisis, Dr Sarra said “While there have been a number of industry and regulatory reports on the crisis, reform proposals to date are too limited in their perspective, in some cases recycling strategies that caused the current crisis.”

She added: “Current reform efforts are in peril of failing to address the real causes of financial market instability.  Regulatory bodies have to think more creatively and systemically about the nature of their task, so that the financial market system can better serve its core purpose of creating long-term sustainable value.”

Five recommendations have been made in relation to point of purchase and sale, with a further five relating to the point of settlement and insolvency restructuring proceedings.

According to Dr Sarra, the aim of the recommended changes is to “ensure that, through the application of rules for transparency and for conduct, buyers are better able to understand and manage the risks of a particular derivative.”

“The proposed changes will ensure credit derivatives can more sustainably and fairly play their vital role as means for diversifying lending risk.”

Professor Sarra added “These recommendations are first steps towards creation of a fair and sustainable credit derivatives market.”

The current system has some perverse effects, said Dr Sarra. “For example, the offloading of risk can mean originating lenders lose any incentive to be duly diligent in the original lending decision. Even more seriously, a creditor can make a loan and then purchase credit default swaps many times the value of the underlying asset. Because the value they would get from settlement of the swaps is greater than the original asset, they then have an incentive to have the debtor company fail and be unable to repay the loan.”

“Implementation of the recommendations would offer immediate protection to investors and create new momentum for the rebuilding of effective, fair and sustainable capital markets.”

While some countries already require some parts of these recommendations, an internationalised derivatives market requires them to be consistently applied across major financial markets.

The recommendations are:

1. Information disclosure sufficient to make informed decisions must be mandatory, not optional.

Disclosure must include:
a. Any adverse risk in the underlying asset.
b. Any risk to the sellers’ financial health.
c. For public companies, how their credit risk has affected valuation of derivative liabilities.

2. Counterparties to credit derivative contracts and investors must have underlying material risks disclosed to them and have enforceable remedies where that risk has not been properly disclosed.

3. Credit rating agencies must meet a mandated due diligence standard

a. They should be required to disclose all fees associated with a rating.
b. Purchasers should have effective remedies against rating agencies and others that do not meet mandated standards.

4. Central exchanges need standardized, transparent trading procedures and consistent standards of conduct and disclosure. That should include:

a. Credit documentation being made public through public registries or similar vehicles.
b. Credit default swaps being publicly reported, including trading and position recording by dealers.
c. A requirement that either a portion of exposure be left on the originating lender’s balance sheet, or that there be a mandatory seasoning period where the lender is required to hold the risk before it can be resold or repackaged.
d. Regulators facilitating the development of best practice standards for over-the-counter derivatives, including counterparty credit risk management, oversight, liquidity management and netting.

5. Where a derivative holder has no economic risk in a loan because it has fully hedged that risk, regulators should mandate that this be disclosed before the holder can precipitate insolvency or other proceedings.

6. If a company is being restructured, there must be mandatory disclosure of the amount of debt that has been hedged by creditors that wish to exercise their rights to participate or vote in the restructuring.

7. A court considering a restructuring plan should be required to take into account the real relative economic interests at stake, as distinct from the interests suggested by the face value of claims that are in fact protected by credit default swaps.

8. Insolvency restructuring legislation should be amended so that credit derivatives can be stayed for a period on the same basis with any other creditor, allowing the court to exercise oversight of the clearing process in a measured way that assists with the risk management aspects of the products and slows the speculative market.

9. Create timely periods for creditors to make claims against the insolvency company, to ensure that debtors can avoid a continually revolving door of credit default swap settlements. Given the internationalized nature of derivatives, these claims bar dates need to be made uniform across different jurisdictions.

10. Finally, a central clearing facility for multiple credit derivatives should be created, with regulatory oversight and transparency.

NSFM is an international, non-partisan network of finance sector professionals, academics and others who see the need for fundamental changes to improve financial market integrity and efficiency.

The NSFM has been formed to bring the insights of theory and practice to bear on the need for a more stable and inclusive financial system, one that will harness the innovative capacity of the financial sector for maximum economic, social and environmental good.

NSFM aims to look at the underlying causes of financial market instability and on development of fundamental reforms.

The paper released today is the first of a series of papers the network is publishing in coming weeks towards the design of a better and more sustainable financial system.

Complete paper available from http://www.sustainablefinancialmarkets.net/

Contacts:    Dr Janis Sarra  - sarra@law.ubc.ca – phone +1 604 947 2071

A few thoughts from Sally Blinken, a former deputy NY State Attorney General who directed numerous public corruption and charity investigations and enforcement actions.  Ms. Blinken is now a litigation partner with Venable LLP in New York.

The Madoff investigations added a new wrinkle late last week as New York Attorney General Andrew Cuomo served subpoenas on 15 separate universities, family philanthropies and non-profit institutions that had been investors with Bernard Madoff’s asset management business.  Among those hit with document requests were Bard College, New York University and New York Law School.

Even though the organizations may have lost more than $100 million in the Ponzi fraud allegedly carried out by Mr. Madoff, questions of due diligence have been raised about relations between some of the non-profits and J. Ezra Merkin, whose own investment funds were active feeders into the Madoff funds.

Mr. Merkin, the former chairman of GMAC, served on the boards of several prominent NY institutions that invested substantially with Madoff, including Yeshiva University, where he was a trustee and headed its investment committee.

Some are wondering why the non-profits - some of whom are bringing their own civil lawsuits against Madoff - would be handed formal subpoenas.

“It seems clear that the Attorney General is taking a serious look at potential conflicts of interest between Mr. Merkin and the institutions he advised, especially those where he served as a director,” Ms. Blinken said.

“Prosecutors are probably trying to learn whether Merkin disclosed his ties with Madoff before actively placing investments on behalf of the foundations and other institutions - and to what degree those ties were known, or perhaps even ignored, by other directors and fiduciaries of those non-profits,” Ms. Blinken added.

She noted that investigators will likely take a close look at minutes of board meetings and other documents showing how investment decisions were made.   “That includes what information Merkin shared on management fees and also allocation figures showing what portion of their investment with Merkin’s three separate funds were being placed with Madoff,” Ms. Blinken noted.

“At the very least, the probe is casting a bright light on the investment policies and protocols in place at some of New York’s leading academic institutions and non-profits,” Ms. Blinken said.

During her seven-year tenure with the AG, Ms. Blinken served as special counsel in the Public Integrity Bureau under Mr. Cuomo.

Sally G. Blinken, a partner in the Commercial Litigation and Nonprofit Practice Groups of the New York office, has seven years experience working in the office of the New York State Attorney General and ten years as a commercial litigation associate specializing in trusts and estates litigation.