Access to material, nonpublic information

Based on their knowledge of material, nonpublic information, creditors may attempt
to buy credit protection and unfairly transfer their risk to credit protection sellers.
Most dealers acknowledge this risk, but see it as little different from that faced in
loan and corporate bond trading. These dealers generally try to protect themselves
against the risk of information asymmetries by exercising greater caution about
intermediating protection as the rating of the reference asset declines. They also may
want to consider requiring protection purchasers to retain a portion of the exposure
when buying protection so that the risk hedger demonstrates a financial commitment
in the asset. Bank dealers also should adopt strict guidelines when intermediating
risk from their bank’s own credit portfolios, for they can ill afford for market
participants to suspect that the bank is taking advantage of nonpublic information
when sourcing credit from its own portfolio. Implementation of firewalls between the
public and nonpublic sides of the institution is an essential control.
When the underlying instrument in a credit derivatives transaction is a security
(as defined in the federal securities laws), credit protection sellers may have recourse
against counterparties that trade on inside information and fail to disclose that
information to their counterparties. Such transactions generally are prohibited as a
form of securities fraud. Should the underlying instrument in a credit derivatives
transaction not be a security and a credit protection seller suspects that its counterparty
possessed and traded on the basis of material, nonpublic information, the
seller would have to base a claim for redress on state law antifraud statutes and
common law.