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Possible Insider Trading Using Credit-Default Swaps??

With great fanfare, the UK's Financial Services Authority ("FSA") announced in June 2006 that it was stepping up efforts to monitor unusual trading activity that possibly could be tied to leaks of inside information about pending corporate events, such as mergers, acquisitions, divestitures, reorganizations and bankruptcy filings. In late October 2006, there is now evidence that such regulatory scrutiny was justified.

On October 27th 2006, Bloomberg reported in an article entitled Credit-Default Swap Traders Anticipated Announcements of LBOs that, according to a study by a New York-based independent research firm Credit Derivatives Research LLC, credit derivative traders may well be profiting from inside information on leveraged buyouts and other corporate events. "Credit-default swaps based on the bonds of 30 takeover targets, including four of the five biggest LBOs of 2006, rose before deals were announced or news reports said transactions were likely, according to the New York-based independent research firm. The fluctuations in credit-default swaps based on the bonds of Austin, Texas-based Freescale Semiconductor Inc., Sara Lee Corp. of Chicago and San Jose, California-based Knight Ridder Inc. were highlighted by the report."

"'The evidence keeps building that there is a problem here,' said Michael Greenberger, former director of trading at the Commodity Futures Trading Commission and now a professor at the University of Maryland School of Law in Baltimore. 'If there continues to be reports of this kind coming out, it's going to suggest that at least a hard look needs to be taken at what's going on.' Credit Derivatives Research found the cost of contracts increased 30 basis points on average during the three months before reports of a transaction. During the same periods, indexes measuring the risk of owning bonds for benchmark companies declined 5 basis points, or $5,000 per $10 million of bonds. 'Evidence shows that CDS prices are widening before public rumor or news,'' said Tim Backshall, a strategist at Credit Derivatives Research in Walnut Creek, California, who conducted the study. 'Whether it's insider trading or more informed selling is unclear. That could simply be a reflection of smart players in the market buying protection.'"

The key issue is that there is no effective regulation of the credit derivatives market. "The SEC says it has no direct supervision of trading, while the CFTC says it isn't responsible. ISDA, a New York-based trade group whose members include the largest credit derivatives dealers, said this month that they aren't aware of any instances of investors using the market to exploit inside information." The FSA has said that this market sector "is very difficult to police'" in part because it is dominated by sophisticated institutions and its participants are less likely "to report suspicious behavior.'''
The Bloomberg article continues "A London Business School study last year of 79 North American companies from 2001 to 2004 found 'significant' evidence that contracts were moving ahead of news that could affect credit quality. ISDA this month issued a statement saying the industry has done an effective job policing itself, and that their 'understanding is that the regulators have been quite happy with the way things are.'"

As more evidence emerges of suspicious CDS trading activity, there no doubt will be calls for better regulation. Hopefully, the regulators will be able to distinguish between insider trading activity and the very useful early-warning function the credit derivative market has become. The Bloomberg article ends with the following: What made Freescale's movement stand out was that it was one of a number of companies that ``did not appear as good candidates for an LBO prior to the event,'' according to [Tim] Backshall. Credit-default swaps have become so useful in predicting takeovers that will hurt bondholders that a growing number of debt analysts are now monitoring derivatives prices as a way to watch for potential deals.

``There is value in monitoring trading activity in these markets for potential `early warning' signals,'' Barclays Capital Inc. strategist Matthew Mish in New York wrote in a note to clients on Oct. 23. Private-equity firms this year have raised a record $300 billion of acquisition funds, meaning the credit-default swap market is on ``a hair trigger now with LBO rumors,'' said [Tim] Backshall. Almost any report of a company being a target of private-equity firms causes prices to ``blow out,'' he said.

Times are certainly getting interesting in the CDS market. Toomre Capital Markets suggests that portfolio, compliance and risk managers particularly monitor this "in the news" sector. Your comments and thoughts are welcome.