July 24 (Bloomberg) -- A ban on “naked” trading in the $26.4 trillion credit-default swaps market being considered by U.S. lawmakers would have the unintended consequence of making it more expensive for companies to borrow, traders said.

“It will inevitably lead to higher costs of funding across all U.S. corporations, significantly reduce liquidity in credit markets, and further widen the opacity” of other instruments that rely on credit swaps for pricing, said Tim Backshall, chief strategist at hedge fund adviser Credit Derivatives Research LLC in Walnut Creek, California, in an interview yesterday.

Credit-default swaps were created as a way for corporate lenders and bondholders to protect themselves from defaults. Naked swaps, where the investor doesn’t own the debt on which the contracts are based, have proliferated in the market and may be prohibited under legislation being drafted by House Financial Services Committee Chairman Barney Frank.

“The question of banning naked credit-default swaps is on the table,” Frank, a Massachusetts Democrat, said in a Bloomberg Television interview yesterday.

Credit-default swaps were used by American International Group Inc. to bet on residential mortgage debt, driving the insurer to the brink of bankruptcy when it couldn’t come up with collateral as prices plunged, and regulators have blamed the market for exacerbating the financial crisis.

The legislation Frank plans to release next week might disrupt the flow of capital to companies by making it costlier for investors to hedge their stakes, said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, a New York-based industry group that sets rules and guidelines for the market.

‘Liquidity and Depth’

“Having people who are in there speculating adds liquidity and depth to the market so that anybody who is a pure hedger, they can tap that market and know they have a deep and liquid market to turn to,” Pickel said in an interview yesterday.

House Agriculture Committee Chairman Collin Peterson said he is helping draft the legislation, which is part of a broader overhaul of oversight of the $592 trillion derivatives industry. Peterson said Frank indicated that he wants a ban on naked trading.

“While the Agriculture Committee had concerns about this proposal when we considered it in February, I am inclined to support it because I would rather err on the side of caution when it comes to these instruments,” Peterson, a Minnesota Democrat, said in a statement through a spokesman yesterday.

Credit-default swaps do “perform a useful function” in the economy, Frank said, and there may be “alternatives to banning naked credit-default swaps” if most derivatives are moved to a regulated exchange.

Trading on Exchanges

“If we can get rules where almost every derivative is traded on an exchange, and those that aren’t because they are just too unique” are backed by extra capital, he said, “then that may do it.”

Treasury Secretary Timothy Geithner defended credit-default swaps at a July 10 joint hearing of Frank and Peterson’s committees, saying the instruments “provide an important economic function” and a ban would be inappropriate.

Representative Maxine Waters, a California Democrat who has a proposal to ban all credit-default swaps, said yesterday she is open to other ideas to ensure the contracts aren’t used to speculate in certain markets.

“What we really need to have is not a ban on naked hedging, but a mechanism -- clearinghouse or an exchange -- where market participants are forced to pony up collateral so that you have a market that doesn’t spin out of control like it did a year ago,” said David Havens, managing director of Hexagon Securities LLC in New York, in an interview yesterday.

Financial Contracts

Derivatives are financial contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather.

One option lawmakers are weighing is setting higher capital and margin requirements for credit-default swaps than for other types of derivatives, Waters said in an interview.

“We knew an outright ban on CDS was going to be highly controversial,” Waters said. “We thought it was important to target this particular type of derivatives because we think it has caused a lot of harm, and we thought to get a decent discussion going, we had to go after it.”

Lawmakers are also weighing some exclusions to an outright ban, including in instances where the “party owns the reference security, or the party has a qualified economic interest or is a bona fide market maker.” Waters said public utilities also may be excluded from any ban.

“That’s the kind of conversation we wanted to create,” she said. “That’s the kind of movement we want.”

Market Makers

Under Frank’s current proposal, market makers would be excluded from the ban on naked credit-default swaps, according to Representative Melissa Bean of Illinois, a Democrat and co- sponsor of a competing bill giving the U.S. Treasury authority over derivatives. Market makers continually buy and sell credit swaps in the over-the-counter market, and often use the swaps to protect against losses.

As much as 80 percent of the credit-default swap market is traded by firms that don’t own the underlying debt, Eric Dinallo, the former superintendent of the New York State Insurance Department, estimated in a January interview.

‘Disapproval Power’

Bean is part of group of 69 lawmakers called the New Democrat Coalition that introduced alternative derivatives legislation July 22. Their Derivatives Trading Accountability and Disclosure Act would create an Office of Derivative Supervision within the U.S. Treasury, with the power to set rules for traders, according to a copy of the bill.

The bill builds off a proposal by President Barack Obama to move standardized derivatives like interest-rate swaps to an electronic exchange or trading platform, and give the Securities and Exchange Commission and the Commodity Futures Trading Commission industry oversight.

The New Democrat Coalition’s legislation would still give the SEC and CFTC authority to propose rules for margin and collateral requirements and determine which contracts must be backed by a clearinghouse or traded on an exchange. The Treasury would have “disapproval power” over any regulations, and could censure or suspend traders or revoke registrations, according to the bill.

To contact the reporters on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net.

Last Updated: July 24, 2009 00:00 EDT