Major swaps dealers told federal regulators Friday that while all traders of over-the-counter (OTC) derivatives should have access to central clearinghouses, actual membership in a clearinghouse should be limited to companies with the ability to absorb another member's default.

"We certainly agree that every customer who is transacting -- every individual and customer who's transacting in OTC derivatives -- should have access to a clearinghouse, should be able to clear their trades through a clearinghouse. That goes without saying...but the second piece of this is who should be a clearing member. And that's where we get into the risk management issues," James Hill, managing director and Global Credit Derivatives officer for Morgan Stanley, representing the Securities Industry and Financial, Markets Association, said during a roundtable discussion hosted by the Commodities Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC).

"The clearing member needs to be able to absorb losses, a default by another clearing member, number one; and number two, they need to be able to absorb the economic transaction risk in the portfolio of a defaulting member," Hill said.

"So it's critical that only trades that can be appropriately risk-managed be put into the clearinghouse. And I think what you'll see is that most of the clearinghouses look to their clearing members to help them evaluate which trades are appropriate from a clearing perspective," he said. Since it's the members' capital at risk, Hill believes they should have a say in helping the clearinghouse evaluate who should become a member.

The joint CFTC-SEC roundtable came one month after President Obama signed into law landmark legislation that lays the groundwork for the biggest overhaul of the financial regulatory system since the 1930s. A key part of the new law is regulation of the OTC derivatives market for the first time (see Daily GPI, July 22). Both agencies are now considering rulemakings to implement the law.

William DeLeon, global head of portfolio risk management with investment firm PIMCO, said that who becomes a member should be a function of the ability to provide capital and support in the case of a member default because "...ultimately there is still commingled counterparty risk going on. And that is the important differentiation."

Jason Kastner, vice chairman of Swaps and Derivatives Markets Association, which represents small traders, disagreed. "The problem with the clearinghouse is not when your smallest clearing member fails. The problem with the clearinghouses is when your highly interconnected, large, same guys are in the room and the top three of them go. That's when you have a problem with the clearinghouse," he said. "So the notion somehow that you should restrict arbitrarily membership...is patently wrong.

"If you look at the BIS [Bank for International Settlements], 96% of the swap market is executed by the largest 10 banks. I think they call that an oligopoly."

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