The commitments presented in this letter will help address weaknesses in the OTC derivatives market. Although efforts by the Federal Reserve and other U.S. and European regulators over the past three years have led market participants to significantly improve many operational elements of the OTC derivatives infrastructure, financial market events have demonstrated that broader action is warranted to address additional market design elements.
The following areas constitute our central priorities for addressing both operational and market design concerns for OTC derivatives:
Institute a Central Counterparty (CCP) for Credit Default Swaps (CDS). As the primary authorities with regulatory responsibility over U.S. CDS CCP proposals, the Commodity Futures Trading Commission, the Securities and Exchange Commission and the Federal Reserve have strongly encouraged CCP developers and market participants to accelerate their efforts to bring a CDS CCP to market. The U.S. regulators are cooperatively reviewing the risk management designs of the U.S. CDS CCP proposals with the objective of granting regulatory approvals as soon as they are determined to meet risk management standards. We are hopeful that one or more CCPs can begin operations in November or December 2008, enabling market participants to rapidly move trades onto a CCP.
A well-managed CCP for credit default swaps will reduce the systemic risk associated with counterparty credit exposures. In addition, a CCP can help facilitate greater transparency of market prices and volumes and support an open trading environment that includes exchange-traded CDS contracts.
Reduce Levels of Outstanding Trades via Portfolio Compression. Market participants continue to reduce the number of outstanding CDS trades through multilateral trade terminations (tear-ups) which lowers outstanding notional amounts, reducing counterparty credit exposures and operational risk. Regulators have instructed firms to maximize the efficiency of trade terminations in CDS tear-ups and have begun monitoring the detailed results to ensure the fullest participation. To date in 2008, tear-ups have eliminated more than $24 trillion of CDS trade notional amounts, reducing the notional amount outstanding by more than one-third. Expanding the efforts from CDS, market participants will start coordinated trade compression cycles for the largest OTC derivatives asset class, interest rate derivatives, in early 2009.
Enhance Market Transparency. Regulators are also seeking to increase the information about CDS that is available to the public. In that regard, we welcome the announcement today by the Depository Trust & Clearing Corporation (DTCC) to publish aggregate market data from the central repository it maintains on credit derivatives. Starting Tuesday, November 4th and continuing weekly, DTCC will release a set of aggregate stock and weekly trade data, including the levels of both gross and net notional CDS traded on the 1,000 largest CDS reference entities. Regulators will continue to work with market participants and service providers to further expand the public release of market data.
Continue Operational Improvements. Regulators continue to demand that market participants improve the back office processes that support OTC derivatives trading. The attached letter details how those efforts are expanding to encompass all major OTC derivatives asset classes and to improve collateral management practices in these markets. Key long-term objectives and milestones in the letter include:
- Use of central counterparty clearing for trades to significantly reduce counterparty credit risk exposure and notional amounts outstanding.
- Target of submitting 85% of eligible CDS trades (including novations) on T+0 by June 30, 2009. (Current target is submitting 92% on T+1).
- Increasing the portion of equity derivatives eligible for electronic matching from 40% to 60% and raising the matching target to 85% for all counterparties.
- Developing plans for central trade repositories for equity and interest rate derivatives.
The New York Fed will continue to work with domestic and international industry supervisors to monitor progress and encourage further effort to improve OTC derivatives operational infrastructure.