Monday, October 20, 2008

Europe gets involved in race for OTC regulation

(FT) When Charlie McCreevy, European Union internal markets commissioner, spoke on Friday of "nasty surprises when things go wrong" in the credit derivatives markets, it was not just another sign of concern over the role that these financial instruments could play in a systemic shock.

It also revealed that Europe realised it risked being left behind in the race to redefine how the vast over-the-counter (OTC) markets operated and were regulated.

In recent weeks, US banking regulators have been pushing aggressively for the creation of a safety valve, in the form of a clearing mechanism, for OTC credit default swaps - financial instruments at the epicentre of the financial crisis that offer a form of insurance when corporate defaults happen.

Authorities and market participants in Europe, especially in the City of London, are growing uneasy with the prospect of a solely US clearing solution emerging, when London - not New York - is where most activity in the CDS and interest rate swaps markets takes place.

Mr McCreevy called on the main players concerned to produce "concrete proposals" by the end of the year on "how the risks from credit derivatives can be mitigated".

He said there was a "pressing need" for a central clearing counterparty (CCP) in such markets. The message appeared to be: we think we need a European solution as well.

Tony Freeman, director of European industry relations at Omgeo, a company specialising in the automation and confirmation of trades, says: "I think what's happening here is clearly transatlantic competition. The argument about the need for a CCP is now over and who gets the job and who runs it is the question that's being discussed."

In the US, two groups are vying to set up a CCP for credit default swaps: CME Group, a futures exchange, and Citadel, a Chicago-based hedge fund; and a group made up of The Clearing Corporation - a consortium of investment banks and interdealer brokers - the Intercontinental Exchange, a futures exchange and OTC trading platform, Creditex, a credit derivatives broker and post-trade processor, and market data provider Markit Group.

The New York Federal Reserve held meetings last week with the protagonists and wanted a solution in place as soon as possible.

In Europe, two exchanges are working on a CCP for credit default swaps. Liffe, the derivatives arm of NYSE Euronext, is collaborating with LCH.Clearnet, its clearer, on the launch of a service called Bclear in the fourth quarter.

Eurex, the derivatives arm of Deutsche Börse, was in New York earlier this month explaining to the Federal Reserve - at the Fed's invitation - its plans for a credit derivatives clearing solution.

Brussels is concerned that the risk associated with OTC credit derivatives is not concentrated in one clearing house based in the US. If there is to be a US-based CCP, the feeling is there should be a second, based in Europe.

Roger Liddell, chief executive of LCH.Clearnet, says the clearer would be interested in offering credit derivatives clearing for Europe, but also for the US.

Mr Liddell says that the industry would be better served having one global clearer for credit default swaps.

Swapclear, the interest rate derivative clearing system owned by LCH.Clearnet, operates on that basis.

But Mr Liddell concedes there is "some slight logic" to having regionally based operations, because "the underlying basket of CDS indices are a little different" in the US and Europe.

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