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CME-Citadel JV Nears Clearing of Credit Default Swaps

Global futures exchange CME Group has gotten the green light from two regulators to begin clearing over-the-counter (OTC) credit default swap (CDS) transactions through CMDX, a joint venture company with Chicago-based Citadel Investment Group. Regulatory reviews by the Federal Reserve Bank of New York and the Commodity Futures Trading Commission (CFTC) are complete, and the last hurdle -- approval by by the Securities and Exchange Commission (SEC) -- is expected soon.

Clearing is expected to to increase transparency and reduce counterparty risk associated with CDS transactions, a form of insurance against the default of debt securities, which have contributed to much of the turmoil in the credit markets. Other exchanges, such as Atlanta-based IntercontinentalExchange (ICE), told the House Agriculture Committee in early December that they also were nearly ready to proceed with clearing of certain CDS transactions (see NGI, Dec. 15, 2008).

The action by the Federal Reserve Bank and the CFTC "puts us a step closer to launching CMDX and bringing stability, transparency and the security of central counterparty clearing to the CDS marketplace," said Terry Duffy, executive chairman of the CME Group.

"CME Group was the first to announce a solution to bring the benefits of centralized counterparty clearing to the CDS market," said CME Group CEO Craig Donohue. "The services we offer will help reduce gross exposures, decrease bilateral credit risk and provide increased efficiencies that will improve overall functioning of the credit markets."

For instance, "our solution allows existing bilateral trades to be submitted and migrated onto the platform for immediate clearing and netting of positions, reducing capital requirements and providing more flexibility for trading in and out of existing positions. From day one, OTC market participants can realize the benefits of clearing with no impact to existing trading strategies, allowing them to inject liquidity into the global capital market," he said.

CMDX is operationally ready and is actively meeting with potential clients from both the buy and sell sides to demonstrate its platform and complete customer onboarding, according to CME Group. Pending completion of an SEC exemption process, it said CMDX will be ready to come to market.

Exchanges, such as CME Group and ICE, moved quickly to enact clearing of CDS transactions following the meltdown on Wall Street, which exposed the faults and defects in the CDS market. ICE is in the processing of forming a limited-purpose bank -- ICE US Trust -- for clearing CDS transactions. It has received approval from the New York State Banking Department, but it is waiting for the Federal Reserve Bank of New York to complete its review and to receive an exemption from the SEC, said ICE spokeswoman Sarah M. Stashak.

So far, the SEC, CFTC and Federal Reserve Bank have approved only one credit default clearing facility, a partnership of NYSE Euronet and LCH-Clearnet Ltd. The three agencies agreed in November to share oversight of the CDS market.

CDS transactions are insurance-like contracts that cover losses on certain securities in the event of a default. "The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft. Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded -- or swapped -- from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults," Newsweek reported last year. It called the CDS market the "eye of the credit hurricane."

U.S. and European exchange officials told the House agriculture last month that they supported Congress issuing a mandate for central clearing to boost transparency and limit counterparty risk in CDS transactions. "We do believe that there should be a mandate for clearing credit default swaps," said Duffy.

Absent a mandate, he estimated that only about 20-30% of the current CDS market, which is estimated at about $54 trillion, would go to clearing.

Without clearing and adequate regulatory oversight, "credit default swaps can pose serious problems to the efficient functioning of our capital markets," Duffy said at the time. "The incentives to sell credit default swaps have led to unfortunate outcomes. Firms have sold credit default swaps that bear risks akin to hurricane insurance, but no regulator required that the firm maintain sufficient capital to fund the disaster that was being covered. Volatile pricing of credit default swaps has had direct and severe adverse impacts on companies whose credit ratings, loan covenants and stock prices were impaired by reported changes in their credit spreads. We understand that some pricing conduct is under investigation, but it is too late for the companies that were most impacted."

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