As the nation's economy struggles to regain its footing, those testifying at a House Agriculture Committee hearing on regulating credit default swaps suggested ways those regulations — and clearinghouses for the transactions — could be set up.

In the often “hard to value credit default swaps market, several companies have stepped forward seeking approval to operate clearinghouses for credit derivatives,” Minnesotan Colin Peterson, chairman, said at the committee's Dec. 8 hearing. “Such clearinghouses could reduce the bilateral risk of swaps transactions and increase transparency of these products — not just for the public but for all players in the industry.”

Given the possibility of central clearing, Peterson hoped the panelists could “shed some light on how this would work given the often complex, specialized nature of many of these products. Issues like margin requirements, standardization of contracts, exchange operating standards, financial security of the clearinghouses in times of stress and the credit worthiness of participants would also need to be addressed if these products were brought out of the dark and onto regulated exchanges.”

As in earlier hearings, Peterson was disinclined to accept proposals for separate Federal Reserve Bank- and Commodity Futures Trading Commission-regulated clearinghouses. Having both would “leave open the possibility that clearinghouses could choose between a regulator with no experience in this area and a regulator with long experience. (Such a structure) looks like it would create the same divided regulatory problem we've already seen on Wall Street and among the largest banks that allowed the biggest players to essentially choose their regulator based on experience, or lack thereof.”

Steve King, a committee member from Iowa, pointed out that credit default swaps serve a valid purpose in the marketplace. “They're an important risk management tool necessary for successful functioning of our financial markets. However, we've learned these financial instruments need appropriate oversight.”

In November, the President's Working Group established a memorandum of understanding regarding credit default swaps markets outlining four important objectives. Those are:

  • To improve market transparency and the integrity of credit default swaps.

  • To enhance risk management of over-the-counter derivatives.

  • To strengthen over-the-counter derivatives market infrastructure.

  • To continue cooperation among regulatory authorities.

Meeting those objectives, said King “will allow for information sharing, will encourage cooperation among regulatory authorities, and will create a method for clearing credit default swaps. … However, as we move forward with developing a clearing mechanism, what remains uncertain is how exactly (it) will reduce counterparty credit risk. What standards in relation to reporting, pricing and assessing risk before a credit event are needed for clearing these financial instruments?”

Potential answers

Along with others sitting before the committee, Terrence Duffy, executive chairman of the Chicago Mercantile Exchange, attempted to answer King's query. First, though, Duffy pointed out recent efforts to reduce gross open credit default swaps exposures have worked — shrinking the original $67 trillion figure to $44 trillion, a drop of 25 percent.

“Ideally, credit default swaps permit investors to hedge specific risk that a particular enterprise will fail or that the rate of failure of a defined group of firms will exceed expectations,” said Duffy. “Credit default swaps are also an excellent device to short corporate bonds, which otherwise could not be shorted.”

Left unregulated, however, “credit default swaps can pose serious problems to the efficient functioning of our capital markets. As has been well-documented, the incentives to sell the 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 severe adverse impacts on companies whose credit ratings, loan covenants and stock prices were impaired by reported changes in their credit spreads.”

While some pricing conduct is under investigation, “it is too late for the companies that were most impacted. Regulators have been unable to judge the market impact of allowing a firm to fail. This is because it is hard to determine what the consequences of the failure would be with respect to their obligations to others and the credit default swaps that would mature.”

Duffy said the swaps can serve an important role in the economy without imposing undue systemic risks:

  • If such swaps are mark-to-market to prices that independently and objectively determined.

  • If the regulators responsible for determining systemic risk can easily keep track of the obligations of banks, brokers, and other participants in the markets.

  • If the well-capitalized and regulated clearinghouses act a central counter party to such swaps.

CME, promised Duffy, has the ability to reduce risk now. “We have presented our plan to the Federal Reserve, the CFTC and the Securities Exchange Commission. We also have addressed regulatory uncertainty in this area. We've urged the SEC to advance the ball by immediately retaining authority to prosecute for insider trading and manipulation that affects securities markets. This should include exempting the trading and clearing of credit default swaps that are cleared by a CFTC-regulated clearinghouse. We remain hopeful that the SEC will take the steps necessary to achieve these important regulatory and systemic risk reduction goals.”

Johnathan Short, senior vice president and general counsel of the IntercontinentalExchange (ICE), said a limited purpose bank, ICE U.S. Trust, would be formed to clear credit default swaps. The trust will be “subject to regulatory and supervisory requirements of the Federal Reserve System and the New York Banking Department.

After final approval, “ICE U.S. Trust will immediately begin clearing current backlogs of credit default swaps trades before moving on to accepting newly executed credit default swaps transactions.”

There are three key points the market still needs to address, said John O'Neill, manager of credit default swaps at Liffe, NYSE Euronext. “The first is same-day confirmation for virtually all trades. The second is accurate and timely mark-to-market pricing. The third is introduction of strong and proven central counterparties for these products.”

If adopted, O'Neill's proposed solution addresses all these points. Through its derivative business, NYSE Euronext “already has a proven system for clearing over-the-counter products — it's called ‘Bclear’ — that has processed over-the-counter transactions with a value of over $8 trillion. It's widely used by all sectors of the industry: banks, brokers and the buy-side. Bclear's products have so far been restricted to over-the-counter equity derivatives. On Dec. 22, we'll also be making credit default swaps contracts available on Bclear.”

O'Neill claimed four guiding principles used in the development of credit default swaps Bclear:

  • Bclear is part of a global solution.

  • “All business in Bclear clears into LCH.Clearnet in London, perhaps the most experienced and respected over-the-counter clearer in the world. U.S. dealers are among the largest users of LCH.Clearnet, both for their U.S.-based and global operations.”

  • Bclear is a proven solution.

  • “We believe the credit default swaps market requires proven and safe solutions. … This is no time for experimentation.”

  • Bclear is an open solution. “The solution should be open to the whole market including the buy-side, sell-side and inter-dealer brokers. We've designed our approach to accommodate this. Significantly, it allows buy-side customers to hold segregated business with clearers. This means the counterparties who held business when Lehmann Brother's collapsed would've been quickly assured of segregated business and safety.”

  • Bclear is a transparent, non-disruptive solution. “The market can get all the security of clearing and processing without asking participants to completely change their business models. Bclear provides this by allowing business to be pre-negotiated, accepted and confirmed. It'll increase the efficient use of capital and reduce stress on financial institutions. It'll also allow regulators to gain transparency concerning the size of positions.”