In a reversal of its previous position, the New York Insurance Department (the “NYID”) announced yesterday that it would regulate, as insurance, certain credit default swap contracts.  The new rules, which go into effect in January 2009, would cover CDS contracts bought by investors that also own the actual bonds or loans referenced by the swaps.  The change would require institutions selling such contracts to be licensed as insurance companies.  However, “naked swaps,” where the buyer or investor does not own the underlying bond, would remain free from regulation as insurance.

In 2000, the NYID ruled that CDS contracts were not insurance, and therefore not subject to NYID oversight.  However, as trade in these contracts has grown to an estimated $62 trillion, and criticism over the role CDS contracts may have played in the recent stock and credit market volatility has risen, regulators in addition to the NYID may feel obligated to step in.  Besides state insurance departments, federal regulators, such as the Securities and Exchange Commission, may become involved in the regulation of the CDS market.

We will continue to monitor the situation and post updates as developments occur.

A copy of New York Governor Paterson’s announcement regarding the regulation of CDS contracts can be found here.