ACCIONES BÁSICAS DE UN SISTEMA DE CONTROL

Before a detailed examination of insurance law principles in the next chapter, it is helpful to clear the ground with some general clarifications. One issue is that there are categories of insurance that have been proposed as appropriate for CDSs, but in fact present some difficulties. Another issue is whether and to what extent the application of insurance law to CDSs may have been already excluded by case law or legislation.

2.2.4.1 Credit Insurance and Financial Guaranty Insurance

According to one representative of United States insurance legislators, credit default swaps are a form of financial guaranty insurance.54 _{The evolving attitude}

of insurance regulators will be examined later, and it will be argued that this view is broadly sound; it is nevertheless opportune to clarify the issue already at this stage, because financial guaranty insurance is a novel and peculiar form of insurance.

Financial guaranty insurance is related to credit insurance, but it is, in the United States, a separately regulated activity that must be conceptually distinguished from ordinary credit insurance.55 _{According to the Geneva}

Association, credit insurance refers to agreements that form part of tradition or core insurance activities and that are generally based on small amounts such as trade insurance (similar to trade finance offered by banks).56 _{In regulatory terms,}

52 _{Ibid. 74–75.}

53 _{“Tiivistetysti CDS-sopimuksista siis puuttuu kaksi keskeistä takaukselle tunnusomaista}

piirrettä: liitännäisyys päävelkaan sekä takaajan regressioikeus.” Ibid. 77. Ahokallio notes (ibid. 93–94) that in Finnish law credit insurance (luottovakuutus) may also include

regressioikeus, highlighting however that this is not automatic right but, in Finnish law, is either due to a separate agreement or to intention or reckless negligence in the causation of the insurance event (vakuutustapahtuman aiheuttaminen tahallisesti tai törkeästä huolimattomuudesta: see VakSopL, § 75.1).

54 _{Morelle 2009: 4.}

55 _{New York Insurance Law (2010 New York Code), for example, has a separate regulatory}

regime for financial guaranty insurance (New York Insurance Law, Article 69) as opposed to normal credit insurance (New York Insurance Law, §1113(a)(17)).The distinction is discussed in the NYSID document New York Department of Insurance General Counsel, Re: Credit Insurance Policy Issued to Financial Institution, Opinion No. 00-06-61 (June 16, 2000), available at http://www.dfs.ny.gov/insurance/ogco2000/rg006161.htm.

CLASSIFYING CREDIT DEFAULT SWAPS:PRINCIPAL ALTERNATIVES

traditional credit insurance does not imply major systemic risks, because the connections to the banking and financial sector at large are small.57 _Financial

guarantees or guaranty insurance, in contrast, is principally offered as a means of providing credit enhancement to bond issuers. This implies larger amounts and significant connections to the financial sector and banks (also because bank capital regulation gives importance to the insurers’ credit ratings).58 _These

regulatory concerns are the main reason why financial guaranty insurance is regulated separately, and insurance companies offering this type of insurance are called “monolines” or “monoliners” because regulations require that they specialize in this activity in order to reduce linkages to other types of insurance.

Importantly, however, financial guaranty insurance is (at least normally) a tripartite arrangement, akin to a letter of credit written by an insurer.59

Analogously to what was argued earlier, therefore, it seems inaccurate to try to fit all CDSs into the category of financial guaranty insurance (see also Figure 5). To be sure, the statutory definitions of financial guaranty insurance are quite broad,60 _{so some CDSs might be caught.}

Figure 5 The financial guaranty insurance triangle.61

2.2.4.2 The Limits of United States Case Law

Regarding the possible exclusion of insurance recharacterization of credit default swaps, let us first briefly examine existing case law. Even in the United States,

57 _Ibid. 58 _{Ibid. 59–60.}

59 _{See Aicher, Cotton and Khan 2004: 930–932.}

60 _{Ibid. 934–935 (describing the NAIC Financial Guaranty Insurance Model Act and the}

relevant New York legislation).

where most decided CDS cases are based, there are few judicial pronouncements on the matter, but there are some obiter dicta on the nature of CDSs. In one case, Judge Jed Rakoff described credit default swaps as essentially an insurance contract, and employed the language of insurance repeatedly: “A credit default swap is an arrangement similar to an insurance contract. The buyer of protection […] pays a periodic fee, like an insurance premium, to the seller of protection […], in exchange for compensation in the event that the insured security experiences default.”62

In another case, the court in contrast sought to differentiate CDSs from insurance, claiming that “CDS agreements are thus significantly different from insurance contracts.”63 _{However, neither decision was concerned with the}

classification issue, but like most CDS cases, they were concerned with whether a credit event had occurred within the meaning of the terms of the contract.64

The latter case nevertheless included some interesting details. Namely, the court cited an ISDA amicus curiae brief, which claimed that CDSs “do not, and are not meant to, indemnify the buyer of protection against loss. Rather, CDS contracts allow parties to ‘hedge’ risk by buying and selling risks at different prices and with varying degrees of correlation.”65 _{However, this generic}

description evades the question of how CDSs are structured, and it does not actually differentiate them from insurance. Moreover, the court adopted a different definition of CDS, which was rather plainer: “Credit default swaps are a method by which one party (the protection buyer) transfers risk to another party (the protection seller).”66 _{This definition is more akin to an insurance}

characterization.

2.2.4.3 New York Insurance Law: The Misquoted Article 69

Regarding United States legislation, there is a surprisingly common but erroneous belief that the insurance classification of CDSs was excluded in New York State in 2004, when Article 69 of the New York Insurance Law (dealing with financial guaranty insurance) was amended to define some aspects of credit default swaps.67 _{Several commentators have claimed that the amendment}

definitively excluded CDSs from insurance regulation, citing the following

62 _{Merrill Lynch International v. XL Capital Assurance et al., 08 Civ. 2893 (JSR), (S.D.N.Y.}

July 15, 2008), at 2.

63 _{AON Financial Products, Inc. v. Societe Generale, 476 F.3d 90, 96 (2d Cir. 2007).}

64 _{Mugasha 2011b: 557–558, who is opposed to the insurance-characterization of CDSs,}

seems to incorrectly rely on the AON case as having decided the matter, ignoring the fact that it was an obiter dicta that did not form part of the legal decision proper.

65 _{AON Financial Products v. Societe Generale, at 96.} 66 _Ibid.

CLASSIFYING CREDIT DEFAULT SWAPS:PRINCIPAL ALTERNATIVES

sentence in § 6901(j-1): “the making of [a] credit default swap does not constitute the doing of an insurance business.”68 _{Thus Shadab writes that New York “in 2004}

codified that position [that CDSs do not qualify as insurance contracts] in Article 69 of the New York Insurance Law.”69 _{Schwartz states that “New York updated}

its insurance laws to exclude CDS in 2004”70 _{and that this “permanently quelled}

the worries of those who feared insurance treatment for CDS.”71 _{Kimball-Stanley}

comments: “The statute is hardly a convincing analysis of the legal issues involved in such a statement; but it is effective nonetheless.”72

But this is all a gross misunderstanding, because the statutory sentence has been taken out of context. The original paragraph defines the meaning of “credit default swaps” for the purposes of New York Insurance Law, and adds acaveat to highlight that the definition only applies on the condition that the agreement is not recharacterized as an insurance contract:

“Credit default swap” means an agreement referencing the credit derivative definitions published from time to time by the International Swap and Derivatives Association, Inc. or otherwise acceptable to the superintendent, pursuant to which a party agrees to compensate another party in the event of a payment default by, insolvency of, or other adverse credit event in respect of, an issuer of a specified security or other obligation;

provided that such agreement does not constitute an insurance contract and the making of such credit default swap does not constitute the doing of an insurance business.73

The underlying logic of this statutory definition is that products knows as “credit default swaps” were being used by New York-based financial guaranty insurers and the legislature sought to add some legal clarity, without however wishing to definitively determine the problem of insurance demarcation, because these novel products functionally resembled insurance. The purpose of the often- partially quoted last sentence was to warn that the application of insurance law to CDSs had not been settled. This interpretation has been emphasized by Insurance Superintendent Eric R. Dinallo, who clarified the meaning of the paragraph in September 2008:

Thus, provided that the making of the CDS itself “does not constitute the doing of an insurance business,” Insurance Law […] permits FGIs [financial guaranty insurance

68 _{Kimball-Stanley 2008: 252 (citing exactly this).} 69 _{Shadab 2010: 429.}

70 _{Schwartz 2007: 173. Relying on this, Sjostrom 2009: 988 asserts: “This [that CDSs have}

not been subject to insurance regulations] was made crystal clear by the state of New York in 2004 when it amended its insurance laws specifically to exclude CDSs from coverage.”

71 _{Schwartz 2007: 183. See also Whitehead 2010: 34 (“In York New […] most of AIGFP’s}

[credit default] swaps were expressly excluded from insurance regulation.”)

72 _{Kimball-Stanley 2008: 252.}

companies] to issue insurance policies that guarantee payments by transformers or other parties pursuant to such a CDS.74

In other words, Article 69 stated that insurers could sell financial guaranty insurance guaranteeing non-insurance CDSs (supposing, of course, that there are such things), which implies that some CDSs could be insurance and their differentiation would have to be determined independently.

2.2.4.4 US Federal Derivatives Legislation: CFMA and the Dodd-Frank Act

The United States is also the jurisdiction that most attention has given to CDSs in federal legislation. It was mentioned above that the Commodity Futures Modernization Act of 2000 (CFMA) expressly excluded their regulation as securities. It also excluded their regulation as commodity derivatives, treating them as exempted swap transactions for this purpose.75 _{Importantly, however,}

the CFMA did not exclude the application of state insurance laws if and when the transactions resemble insurance.76 _{The underlying principle here is that the}

CFMA was not concerned with the insurance question, but with the question of whether certain financial products (mainly other OTC derivatives, to which CDSs were added) would be caught by the existing federal regulatory schemes. Insurance law, in contrast, is a state matter in the United States, and the legislation in question did not address it.

In contrast, the Dodd-Frank Act of 2010 expressly excluded the characterization and regulation of CDSs as insurance under state law.77 _The

Dodd-Frank reform will be examined later in detail, but even regarding the insurance law issue it must be noted that, apart from failing to satisfy policy concerns, the Dodd-Frank insurance pre-emption is legally confusing, because it depends on a paradoxical concept of “swap” that departs from financial definitions and may end up covering many insurance contracts.78 _{Moreover, it}

does not determine the question in other jurisdictions.

74 _{Dinallo 2008a: 7. See likewise Venokur, Magidson and Singer 2008: 5, writing that “if}

the CDS itself does not constitute an insurance contract or the doing of an insurance business, then an FGI is permitted to issue an insurance policy that guarantees payments by a transformer or other party pursuant to such CDS.”

75 _{Sjostrom 2009: 986; Wynkoop 2008: 3100.}

76 _{Dinallo 2008b: 4 explains the effects of CFMA and highlights that the insurance issue}

was left open. Schwartz 2007: 173 also notes that “the state of insurance regulation remains unsettled in many places”.

77 _{See below, chapter 4.3.3.}

CONCLUSION

2.2.4.5 European Union Legislation: The Limits of EMIR and MiFID

In contrast to the United States, the legal characterization of CDSs, particularly with respect to insurance law, has received little legislative attention in Europe. To be sure it is commonly assumed that CDSs are derivatives, but the legal foundation for this assumption is rarely or never clarified.

For example, the new EU regulation imposing mandatory clearing for many OTC derivatives—commonly known as the European Market Infrastructure Regulation or EMIR—is normally assumed to cover CDSs, but in fact it makes no explicit reference to credit default swaps. In fact, it defines “derivative” or “derivative contract” by referring back to a list of instruments attached to the MiFID Directive.79 _{This list, however, does not mention credit default swaps, but}

simply refers generically to “Derivative instruments for the transfer of credit risk”.80 _{If this is the legal basis for holding that CDSs are not insurance, on}

reflection it is frankly quite inadequate: the non-specific expression in MiFID does not provide any demarcation criteria, and it simply presupposes prior legal classification as a derivative; invoking it as a statutory classification would therefore be circular.

Naturally, to say this is not to deny that it is probably very common to suppose that CDS are “financial derivatives” and that the notion of financial derivatives is legally and economically clear and uncontroversial, so that the application of MiFID, EMIR and so on to credit default swaps would also be uncontroversial.81

It is precisely in order to problematize this assumption that I have sought to highlight the conceptual difficulties underlying the notion of financial derivatives. For the same reason, the following chapters will carefully analyze not only the problem of demarcating insurance law, but also to the issue of how the notion of financial derivatives, and more specifically, the notion of “swaps”, has arisen and evolved in financial regulation.