Tuesday, October 15, 2013

Do Credit Derivatives Make the Concept of Insider Trading Meaningless?

Though scholarly debates continue, the impact of credit derivatives on the law and policy of insider trading is still unexplored. This Article fills this gap to demonstrate that the emergence of credit derivatives marks a profound development for the prohibition against insider trading. It argues that the growth of credit derivatives problematizes traditional insider trading jurisprudence like never before. With the feasibility of current rules subject to question, this Article advocates for a radical rethinking of the present regulatory framework for one better suited to modern markets.

In his paper published August 28, 2013, Yesha Yadav of Vanderbilt Law School posits that the rise of derivatives like credit default swaps (CDS) has made the concept of insider trading inoperable in markets where these derivatives trade.  Yadav's paper, "Insider Trading in the Derivatives Market (and What it Means for Everyone Else)," asserts that the credit derivatives markets actually may be more efficient by factoring in insider knowledge and transmitting this information more freely.

The prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) operate. Lenders use these instruments to trade the credit risk of the loans they extend. By design, CDS appear to subvert insider trading laws, insofar as lenders rely on what looks like insider information to transfer or externalize the risk of a loan to another institution. At the same time, the harm caused by using insider information in CDS markets can depart radically from the harms envisioned under existing case law. In the traditional account of insider trading, shareholders systematically lose against informed insiders. However, with CDS trading, shareholders of the debtor company can emerge as winners where this company enjoys access to cheaper credit and lower funding costs. 

According to Yadav, the operation of the CDS market changes the assumption that shareholders lose when insiders trade using non-public information.

This Article shows that trading on insider information in CDS can improve at least the informational, if not also the allocative efficiency of financial markets in ways traditional accounts have scarcely anticipated. However, in doing so, CDS markets reveal that this informational gain can render markets "too" efficient where they impound new information selectively and with such force that market stability itself can suffer. Collectively, these observations suggest a need to revisit the insider trading prohibition itself – and to explore whether consistency can (and should) be brought to supervisory approaches in U.S. equity and derivatives markets.

Prior to Dodd-Frank, the CDS market lived outside the insider trading rules, and the credit derivative market has operated using insider knowledge almost freely.  New rules, however, expand the reach of the insider trading prohibition explicitly including the credit derivatives market.  

Lenders that trade credit derivatives pose a significant challenge to conventional doctrine. At their core, insider trading rules prohibit trading based on information procured at an unfair advantage by those in a privileged relationship to a company.  In the universe of credit derivatives, lenders usually buy and sell credit protection based, at least in part, on information they obtain in their relationship with the borrower. The access to information that lenders enjoy, alongside their influence on management, helps lenders exit their investment using CDS quickly and cost-effectively. This, after all, is the very nature of the market. Finance scholars have long recognized that credit derivative markets showcase an unmistakable tendency towards insider trading, at least in a functional sense.

Yadav argues that the concept of insider trading is a bad fit for the CDS market, and a thorough rethinking of the traditional theories of insider trading is necessary to account for the efficiency and information sharing attributes of the credit derivatives market.