(Bloomberg) -- Persuading a company to default on debt to cash in on contracts insuring against that very prospect is an abuse that will damage the reputation of the market, according to the head of the U.K.’s financial watchdog.

Corporate credit-default swaps pay holders if a borrower fails to repay its debts. The instruments have come under scrutiny after a unit of Blackstone Group LP bought protection on the debt of ailing U.S. homebuilder Hovnanian Enterprises Inc. and offered it cheap refinancing in return for agreeing to default on a bond. Hedge funds that were on the hook for losses sued.

“This is a practice that’s the wrong side of the line,” Financial Conduct Authority Chief Executive Officer Andrew Bailey said in an interview, without referring to Blackstone. “This is not what that instrument is there for. If you have artificial engineering of defaults, this will actually bring the thing into disrepute.”

Bailey is the latest figure to weigh in on the obscure corner of the $10 trillion market for credit derivatives that were originally meant to protect lenders against the borrowers’ demise. The U.S. Commodity Futures Trading Commission, as well as senior executives at firms embroiled in Hovnanian’s CDS including Citadel Securities LLC and Goldman Sachs Group Inc., have expressed disapproval or called for reform.

BOE Curbs?

Bailey has discussed so-called engineered defaults with CFTC Chairman Chris Giancarlo and has asked the International Swaps & Derivatives Association, a body of finance-industry insiders that decide when CDS contracts are triggered, to curb them in future. ISDA declined to comment beyond an April 11 statement that officials were considering whether to restrict “narrowly tailored defaults.”

The Bank of England, a separate institution from the FCA, is also consulting asset managers about whether to curb technical defaults tied to traders’ positions in credit derivatives, according to two people familiar with the matter. The central bank first held meetings earlier this year to canvass views, said the people, who asked not to be named discussing private meetings. A spokesman for the BOE declined to comment.

In Europe, controversial defaults earlier this decade include Spanish gaming company Codere SA and Norwegian paper company Norske Skogindustrier ASA.

ISDA may decide to investigate a lender’s intentions or a debtor’s true creditworthiness in future decisions about CDS payouts, though such subjective questions risk opening a “Pandora’s box,” said Robert Pickel, a former head of ISDA who advised a hedge fund on the other side of Blackstone’s Hovnanian trade. ISDA should find a fix soon so that traders can trust CDS ahead of a future economic downturn, he said.

“We have the luxury of trying to address this now in a benign environment,” Pickel said. “There’s pretty broad consensus that something should be done.”

(Updates with further news and commentary from sixth paragraph.)

To contact the reporters on this story: John Glover in London at johnglover@bloomberg.net;Thomas Beardsworth in London at tbeardsworth@bloomberg.net;Katie Linsell in London at klinsell@bloomberg.net

To contact the editors responsible for this story: Neil Callanan at ncallanan@bloomberg.net, Jon Menon, Keith Campbell

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