The prohibition against insider trading is growing increasingly out-of-date in markets where credit derivatives like credit default swaps are traded, says a Vanderbilt Law School professor.
鈥淟enders use credit default swaps to trade the risk of the loans they make,鈥� says , assistant professor of law. 鈥淎nd, when they engage in such trading, they are usually privy to vast reserves of confidential information on their borrowers.鈥�
鈥淸rquote]Credit default swaps appear to subvert insider trading laws by their very design.鈥漑/rquote]
Insider trading laws prohibit trading based on information procured through an unfair advantage by those in a privileged relationship to a company. Following the financial crisis of 2007-08, such laws have been used in a series of important cases to sanction Wall Street and check market abuse.
鈥淎 series of high-profile actions for insider trading offenses have demonstrated the bite as well as the bark of existing rules,鈥� Yadav writes in .
鈥淩ecent legislation has expanded the reach of the insider trading prohibition to explicitly include the credit derivatives market.鈥�
Some finance theorists have already noted that credit derivatives markets exhibit tell-tale signs of insider trading. Credit default swap markets often anticipate market events months and sometimes even years before they happen, particularly with respect to 鈥渘egative鈥� events, such as a credit downgrade or bankruptcy 鈥� in other words, events that lenders are most concerned about.
鈥淥ld laws and new credit default swap markets appear to exist in a state of serious tension,鈥� Yadav says. 鈥淓ither this thriving market is operating outside or at the margins of existing law 鈥� or the law itself has not adapted to the existence of these markets.鈥�
Yadav suggests taking another look at the prohibition against insider trading, and to explore whether there is a consistent standard that can work for both equity and derivatives markets.