Credit Default Swaps and Insider Trading

Abstract

In the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Congress clarified that the insider trading regime of Rule 10b-5 applies to trading in credit default swaps. In so doing, Congress implicitly assumed without analysis that the equities securities markets and the credit default swap market are the same and should be subject to the same rules.

This paper is the first to question that assumption and to consider whether as a normative matter credit default swaps should be subject to Rule 10b-5. Through a rigorous analysis of the differences between the two markets and the policies underlying the rules prohibiting insider trading in equity securities, it demonstrates that there would be significant public benefits from permitting insider trading in credit default swaps, including mitigating the serious problems of equity bubbles and overvaluation. Moreover, the reasons for prohibiting insider trading in the equities securities markets are not applicable to or apply with far less force to transactions in credit default swaps. Accordingly, this paper recommends that credit default swaps be excluded from the ambit of the insider trading rules.

Keywords: insider trading, CDS, credit default swap, securities

JEL Classification: G14, G18, K22, K42