Tuesday, October 28, 2008

Fed Sets Deadline for Details on Backing Credit Swaps

(Bloomberg) The Federal Reserve has given U.S. futures exchanges until Oct. 31 to present written plans on how they'll make the $55 trillion credit swaps market less risky, according to four people familiar with the discussions.

CME Group Inc. and Intercontinental Exchange Inc., the two biggest U.S. futures markets, are among companies vying for a share of the market for guaranteeing credit-default swaps, the volatile contracts blamed for the current financial crisis. As much as $100 million in revenue may be generated within a year by processing the trades, according to Wachovia Capital Markets.

The Fed is pressing the industry to set up a central counterparty that would absorb losses should a market maker fail, a step that might have avoided last month's bankruptcy of Lehman Brothers Holdings Inc. The process may be heading toward a conclusion, said Brian Yelvington, a strategist at fixed- income research firm CreditSights Inc. in New York.

``It's crunch time, people are ready to go,'' Yelvington said. ``You're going to see one of these solutions come to fruition in the next four weeks.''

The Federal Reserve Bank of New York is seeking details on how credit-default swaps would be settled by a clearinghouse, how trades would be processed, what safeguards are in place in the event of a trader bankruptcy and how the system will insure against a meltdown similar to Lehman Brothers, according to the people, who asked not to be named because the talks are private.

Fed Meetings
Federal Reserve officials are not aiming to pick a winner to operate a clearinghouse, the people said. Rather, the central bank is hoping to set up a framework for the eventual winner. The regulator is meeting today and plans sessions Oct. 30, Oct. 31 and Nov. 4, one of the people said. Each meeting focuses on separate issues of how the clearing will work, the person said.

The Fed met with clearinghouse owners three times in the past several weeks, including individual sessions and group discussions. Regulatory approvals to enact a framework may be in place as early as mid-November, the people said.

Credit-default swaps pay buyers face value for the underlying securities, or a cash equivalent, should the company fail to keep to its debt agreements. The swaps are blamed for hastening the bankruptcy of Lehman Brothers by driving down the investment bank's equity value.

Because CDS contracts are traded bilaterally by banks, hedge funds, insurance companies and other institutional investors, each party faces the risk of losses should their trading partners default.

Four Groups
A clearinghouse, capitalized by its members, all but eliminates the risk of trading-partner default by being the buyer for every seller and the seller for every buyer. It employs daily mark-to-market pricing and liquidates positions of traders who can't pay their margin.

The four groups vying to operate clearing operations include partnerships of Chicago-based CME Group and Citadel Investment Group LLC, and Intercontinental Exchange, dealer- owned Clearing Corp. and credit-swap index owner Markit Group Ltd. Eurex AG and NYSE Euronext also have submitted proposals.

NYSE Euronext's Liffe derivative exchange in London will begin clearing contracts based on the European benchmark iTraxx indexes of credit-default swaps this quarter, the company said in July.

NYSE Euronext Chief Executive Officer Duncan Niederauer said the proposals by the CME-led group and the Clearing Corp.- backed plan are too focused on the U.S. market.

``This is a global problem,'' he said today at the annual meeting of the Securities Industry and Financial Markets Association in New York. ``It's not a regional problem.''

Transparency
The NYSE plan is ``stronger'' for European CDS contracts, Niederauer said. ``There is a lot more transparency that we can bring to bear'' on the CDS market.

CME Group spokeswoman Mary Haffenberg, Intercontinental Exchange spokeswoman Kelly Loeffler and Clearing Corp. spokesman Andy Merrill declined to comment. Citadel spokeswoman Katie Spring referred questions to CME Group.

Citadel and CME Group this month proposed clearing CDS using CME's clearinghouse for futures contracts to back the credit trades. Intercontinental Exchange and Clearing Corp. plan to create a separate clearinghouse to segregate its futures and credit-swaps business.

Some CME Group members are concerned about mixing the clearing of futures and credit swaps contracts in a single clearinghouse, because their money is used to fund any trading default.

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