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Exchanges Call for Mandated Clearing of Credit Default Swaps

U.S. and European exchange officials last Monday said they supported Congress issuing a mandate for central clearing of credit default swaps (CDS), a form of insurance against the default of debt securities, which have contributed to much of the tumult in the credit markets. U.S. exchanges say they are ready or near ready to proceed with clearing of certain CDS transactions to increase transparency and limit counterparty risk.

"We do believe that there should be a mandate for clearing credit default swaps," said Terrence A. Duffy, executive chairman of CME Group, the world's largest futures exchange, formed by the merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the subsequent acquisition of the New York Mercantile Exchange.

Absent a mandate, he estimated that only about 20-30% of the current CDS market, which has shrunk to about $44 trillion since the start of the financial-credit crisis, would go to clearing.

"We likewise believe clearing should be mandated for most CDS instruments," particularly those that are widely traded and have systemic risk implications, Johnathan H. Short, vice president and counsel for Atlanta-based IntercontinentalExchange Inc. (ICE), told the House Agriculture Committee during a hearing to review the role of credit derivatives in the U.S. economy.

A "mandate would certainly help to facilitate that process" of migration of CDS transactions to a central clearing process, agreed Thomas Book, member of the executive board of Eurex Clearing AG in Frankfurt, Germany.

They also agreed that indexed, standardized products would be the easiest to mandate and should be the first to go through the clearing process. The ones that would pose the most risk and would require more time for clearing would be the illiquid or toxic products.

CDS transactions are insurance-like contracts that cover losses on certain securities (bonds) 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 earlier this year. It called the CDS market the "eye of the credit hurricane."

If not the cause of the past year's credit conflagration, The Economist in November said CDS transactions were in certain respects the accelerant. It quoted a former securities regulator as saying the CDS market was a "Ponzi scheme" that no self-respecting company should touch.

Should a mandate be imposed by Congress, "CME Group is prepared now to go forward with its solution to meet any mandate for credit default swap contracts," Duffy said. "We have formed a joint venture with the Citadel Investment Group and have immediate operational capacity to offer a compression facility and clearing house for standardized credit default swaps and to migrate a high percentage of previously traded swaps into a standardized, cleared environment that will provide regulators with the information they need and customers with a lower-cost, lower-risk and more efficient market."

"We have presented our plan to the Federal Reserve, the CFTC [Commodity Futures Trading Commission] and the SEC [Securities and Exchange Commission]. We have addressed regulatory uncertainty in this area by urging the SEC to immediately advance the ball by retaining authority to prosecute for insider trading and manipulation that affects securities markets and otherwise exempting the trading and clearing of credit default swaps that are cleared by a CFTC-regulated clearing house...We are working with...the SEC and CFTC to secure a workable set of exemptions that will give this solution a chance to succeed."

ICE plans to form a limited-purpose bank -- ICE US Trust -- to clear CDS transactions, said Short. It will be a New York trust company and a member of the Federal Reserve system, and will be subject to regulatory and supervisory requirements of the Federal Reserve system and the New York State Banking Department.

He said ICE's application and charter were approved by the New York State Banking Department earlier this month. And the Federal Reserve Bank of New York currently is reviewing ICE's application. "We believe that we are in the final stages of that review."

Once approved, ICE Trust will immediately begin clearing current backlogs of CDS trades before moving to accepting newly executed CDS transactions, he told House lawmakers.

Without clearing and adequate regulatory oversight, "credit default swaps can pose serious problems to the efficient functioning of our capital markets," CME's Duffy said. "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."

Some have called CDS trades "gambling devices or instruments of mass destruction, [but] we do not take that view," Duffy said. "If such swaps are marked-to-market to independently and objectively determined prices, if the regulators responsible for controlling system risk can easily keep track of the obligations of the banks, brokers and other participants in the market, and if a well capitalized and regulated clearing house acts as the central counterparty for such swaps, we believe that they can serve an important role in our economy without imposing undue system risks."

Acting CFTC Chairman Walter Lukken last month called for the agency to move aggressively to oversee the clearing of CDS transactions ( see NGI, Nov. 17).

Within days of Lukken's remarks, the President's Working Group on Financial Markets announced that it was moving to oversee the successful implementation of central counterparty services for CDS trades to reduce the "systemic risk" associated with counterparty credit exposures and to boost transparency in the market. The CFTC, SEC and the Board of Governors of the Federal Reserve System also signed a memorandum of understanding that establishes a framework for consultation and information sharing on issues related to CDS central counterparties.

Commissioner Bart Chilton, whose name is being tossed about as a possible successor to Lukken in the incoming Obama administration, echoed Lukken's sentiment, but he added that more needs to be done. "This is indeed a laudable goal. It is but one part, however, of a comprehensive review of regulatory oversight of the OTC [over-the-counter] derivatives market, sorely needed in the United States. We need the ability to see into these 'dark markets,' as well as the ability to act should we detect problems," he said.

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