Regulators’ push for CDS clearinghouse betrays concern

U.S. and foreign regulators’ push for a clearinghouse to process the $2 trillion worth of credit-default swaps that trade annually underscores fears of lingering systemic risk tied to over-the-counter derivatives.

“The objectives of regulatory policy should be to improve the capacity of the financial system to withstand the effects of failure and to reduce the overall vulnerability of the system to the type of funding runs and margin spirals we have seen in this crisis,” Timothy Geithner, president of the Federal Reserve Bank of New York, told The Economic Club of New York on June 9.

Mr. Geithner spoke shortly before a meeting held at his bank to discuss the potential systemic risk related to the CDS market and solutions to prevent problems from spinning out of control.

The New York Fed last March spearheaded the hasty $40 billion rescue of Bear Stearns Cos. amid the OTC collateralized debt obligation market’s debacle.

The attendees included representatives of 17 financial firms, accounting for 90% of credit derivatives trading, and, for the first time, institutional investors with a strong CDS presence — AllianceBernstein LP, Blue Mountain Capital Management LLC, both in New York, and Citadel Investment Group LLC, Chicago — as well as representatives of four major industry groups.

Thirteen U.S. regulators and three of their foreign peers from France’s Commission Bancaire, the Swiss Federal Banking Commission and the U.K.’s Financial Industry Regulatory Authority also attended the meeting.

“There is a sense among regulators that we cannot go through another Bear Stearns, a sense that they have to be more proactive in OTC derivatives markets. The firms welcome more transparency as well,” said an executive at a clearing firm who asked not to be named. The New York Fed has slated another meeting for July 31, to assess the progress made toward implementing the agenda agreed upon at the initial meeting, which included, besides the development of a clearinghouse: further automation for same-day trade matching; increasing transparency with an auction-based settlement system; and reducing the volume of outstanding credit by terminating multilateral trades.

The regulators’ efforts to limit counterparty risk in the CDS market are timely.

According to Standard & Poor’s Managing Director Diane Viazza’s June Global Fixed-Income report, “the number of entities at risk of (credit rating) downgrades reached a new record of 738 in May,” and two-thirds are for companies based in the U.S.

“The upsurge in the count of entities at risk of downgrades began in mid-summer 2007 with the onset of a material erosion of the residential real estate sector and large write-downs by financial institutions,” Ms. Viazza wrote. “The number of potential downgrades is 103 more than the average recorded in the year 2007.”

A weaker rating increases the cost of funding, thus lifting the risk of default as companies find it difficult to refinance or roll over their debt. As a result of the bearish outlook, the demand for insurance against debt holdings has soared, boosting the CDS market to $62.2 trillion in notional value at the end of 2007 or an 81% increase compared to a year earlier.

“These numbers are misleading. What matters is not the notional value but the actual exposure that counterparties have with each other, which may be around 1% or 2% of the notional value,” George Handjinicolaou, deputy chief executive officer for the International Swaps and Derivatives Association in London, said in an interview. The ISDA was represented at the Fed meeting.

In its November 2007 report on OTC derivatives, the Bank for International Settlement reported that the notional value of OTC derivatives stood at $516 trillion, but the gross market value of the contracts were only $11 trillion.

“OTC derivatives have revolutionized the financial world in the last 20 years, as the most vibrant, dynamic market. CDS are another wave in that ocean, but the whole concept of derivatives transformed how we think of risk and risk management,” Mr. Handjinicolaou said. “Regarding the issue of central counterparty clearing, there are different solutions to consider.”

Several firms that attended the meeting have a stake in Clearing Corp., or CCorp, Chicago, a derivatives clearinghouse. Because CCorp is not owned by a derivatives market, it appeals to dealers who fear that exchanges are trying to encroach on their profitable OTC turf.

CCorp plans to start clearing CDS trades in September, beginning with the CDX North American high-yield and investment-grade benchmark indexes. Later, CCorp intends to clear iTRAXX a European and Asian CDS indexes as well as contracts based on single issuers. Late last month, the Chicago clearinghouse announced an agreement with The Depository Trust & Clearing Corp. to support its central counterparty OTC services. CCorp users will have access to DTCC’s Trade Information Warehouse, which tracks OTC CDS transactions through the life of the contracts, including net open positions and post-trade information.

DTCC Director Judith Inosanto said that, by leveraging the Warehouse’s repository and post-trade capabilities, CCorp “will strengthen the CDS market’s infrastructure and reduce risk for its participants.”

Meanwhile, derivatives exchanges are interested in what could be the next big area of growth for their clearinghouses.

“We actually guarantee the performance of every transaction in our market. Last year alone, we traded more than 2.2 billion contracts, worth a notional face value in excess of a quadrillion dollars,” Craig Donohue, chief executive officer of CME Group Inc., Chicago, said of his exchange’s clearing system while addressing a Sandler O’Neill + Partners LP, New York, conference on June 6.

Mr. Donohue questioned whether a broker-owned clearinghouse would provide the same level of safeguards or expertise.

“People are becoming very cognizant of the differences between our value proposition in exchange-traded, centrally cleared markets and the OTC market where they don’t have that twice-daily marked-to-market regime or they may not have that independence in neutrality in terms of how to mark positions and how to value exposure in the market,” the CME chief added.

On June 3, IntercontinentalExchange Inc. said it would buy Creditex Group Inc, New York, which handles and processes credit default swap trades in the U.S., Europe and Asia, as the Atlanta-based exchange group shares the CME’s view that OTC clearing is a new frontier for the regulated markets.

In addition, brokerage firms are trying to increase transparency in OTC derivatives. JPMorgan Chase & Co., New York, has just introduced an automated reconciliation feature as part of its derivatives collateral management service.

Contact Isabelle Clary at [email protected]