Monday, November 3, 2008

Swap Meet

(The Deal Newsweekly) Regulators looked the other way while credit default swaps grew into a $60 trillion threat to the world's financial system. Now the CDS market is getting plenty of attention, and brawling has broken out over how to regulate it and who should oversee the job.

Enticed by what promises to be a lucrative business, clearing companies and exchanges are vying to establish trading platforms. The Securities and Exchange Commission, the Commodity Futures Trading Commission and the Federal Reserve Bank of New York are claiming the right to be the primary regulator of derivative securities. And various congressional committees are bickering over which will have jurisdiction to oversee the market and the agency eventually assigned to supervise it.

Already, three federal agencies and one state agency have different ideas for how the market for credit default swaps should be regulated. Meanwhile, congressional finance, banking and agriculture committees that oversee the regulators are also jockeying for position. There appears to be agreement that the market should not operate without added oversight, but disagreement is wide over how to structure a market for CDSs and how direct the government's oversight should be.

Businesses trying to establish the new market include CME Group Inc.; NYSE Euronext Inc.; IntercontinentalExchange Inc. or ICE; Eurex, the derivatives arm of Deutsche Börse AG; and Knight Capital Group Inc. Futures giant CME, with hedge fund Citadel Investment Group LLC, is offering to create a platform that would clear trading of credit default swaps by matching buyers and sellers, guaranteeing that both would have the financial strength to stand behind their trades. Then, on Oct. 30, ICE announced it agreed to acquire the Clearing Corp. and signed agreements with nine banks, bolstering its position to establish its trading platform.

Initially, it looks like Ben Bernanke's Federal Reserve will oversee the nascent trading platform. According to ICE officials speaking on a conference call last week, the exchange sought to design a clearing model for CDSs that would be subject to Fed oversight, since the central bank was taking a pre-eminent role in addressing the credit crisis.

The Fed wants details on how CDSs would be settled by a clearinghouse, how trades would be processed, what safeguards exist if a trader or a dealer defaults and how the system will protect against a financial crisis.

But the SEC also wants to regulate CDSs, as does the CFTC. It's unclear whether the Fed will maintain its oversight or whether it will eventually hand it off to one of the other agencies.

The Commodities Futures Modernization Act barred the CFTC from regulating most swap products in 2000. During the swaps explosion, neither the CFTC nor the SEC were willing to buck the Bush administration's deregulation policies. With markets in disarray, both are fighting for the right to preside over swaps. The CFTC says they're futures contracts and thus are under its jurisdiction. The SEC says they're financial instruments with no connection to agriculture or raw materials futures.

Despite the SEC's recent abysmal performance, Chairman Christopher Cox has said the agency is prepared to regulate swaps with the same authority it has over stocks and bonds. The CFTC may argue that at least one industry proposal for a new platform for settling swap contracts would give it top duties.

Walter Lukken, the CFTC's acting commissioner, told lawmakers at an Oct. 14 hearing that current law exempts swaps from regulation and that "wholesale regulatory reform will require careful consideration." He should know -- Lukken helped craft the law barring the CFTC from regulating most swap products when he was a Republican congressional staffer. Enron Corp., the biggest energy derivative merchant in the U.S. at the time, lobbied heavily for the exemption, which was sponsored by then-Sen. Phil Gramm, ­R-Texas. Now Lukken is conceding that some regulatory structure is necessary.

Congress could simply merge the SEC with the CFTC. Treasury Secretary Henry Paulson proposed such a step in March, saying a single securities and futures regulator would better reflect how deeply entrenched Wall Street is in many markets. And before the House Committee on Oversight and Government Reform last week, Cox said he "strongly supports" a merger.

New York state has moved recently to regulate some CDS contracts because of their insurance component, proposing that the seller may have to be licensed as an insurer in New York.

The outcome of the turf war will have practical implications for how the platform will work. The CFTC and the New York Fed favor a less regimented clearinghouse platform; the SEC wants a more formal exchange.

The clearinghouse would charge a fee and act as an intermediary that would guarantee transactions between swaps traders. To make those guarantees, the clearinghouse would require traders to maintain sufficient capital in their accounts. That would make it hard to trade without the money to cover a contract in case of default.

Working with the New York Fed is the ICE, which plans to set up in New York under Fed authority. Some of the country's biggest banks, including Goldman, Sachs & Co. and Morgan Stanley, established ICE. In June it bought Creditex Group Inc., which executes and processes swaps in the U.S., Europe and Asia. Creditex and subsidiary Markit Group Ltd. recently liquidated swaps of Fannie Mae, Freddie Mac and Lehman Brothers Holdings Inc. That could give it a leg up in the battle.

CME Group and hedge fund Citadel would not only trade CDSs on a new platform but also use CME's clearinghouse to clear swaps. CME would get involved as counterparty in every CDS trade and manage the credit exposures from the time the trade is made to when the trade is officially settled. The CFTC now oversees its operation.

NYSE Euronext London-based subsidiary Liffe also plans to process and clear swaps. The service, announced in July and called Bclear, now clears equity derivatives trades and would remove counterparty risk by using LCH.Clearnet Group Ltd. as a central counterparty to all the CDS contracts it processes.

If Congress grants the SEC power to oversee swaps, the agency could set up several exchanges, similar to the New York Stock Exchange and Nasdaq.

Stephen Figlewski, a professor of finance at New York University's Stern School of Business, wrote in a recent paper that the over-the-counter CDS market needs such an exchange. Clearinghouses "are too fragile, too loosely regulated and too opaque," he wrote.

There's been resistance: An exchange would reduce the ability to customize CDS contracts, reducing their profitability. "Trading CDSs on an exchange will make them much more standardized," says Howard Spilko, a partner at Kramer Levin Naftalis & Frankel LLP in New York. Spilko adds that CDSs have specialized terms that go with them that counterparties need to negotiate. "They're not plain vanilla."

CDSs were toxic partly because they were traded and retraded past the point of knowing who the original sellers were and their value. That uncertainty had a snowball effect with each failure. The use of an exchange provides a middleman for each transaction, so the buyer and seller are identified. If there is a problem, fallout is limited. Swaps would be marked to market each day.

Dealers also fret that their lucrative business will be transformed, with exchanges not only executing but designing their own products. "Exchanges are not just a utility anymore, they're a competitor," says Bob Paul, a former general counsel to the CFTC now with DLA Piper's alternative asset management team in New York.

It's doubtful, however, that one platform or exchange will be the sole recipient of so much business. Competition should make it less expensive for parties to trade. What will be more telling is whether the desire to concentrate liquidity and have a deep pocket will necessitate one platform winning out over other exchanges and dealers. Whichever company is picked must offer what thus far has been absent in the market for CDSs: transparency and more efficient risk management.

Much depends on how Congress settles its own jurisdictional squabbles. The turf fights among congressional committees with a claim to jurisdiction will be fierce. Authority over a giant new trading platform will bring presiding lawmakers not only power, but offer a new source of campaign contributions from the financial industry. "It's a minefield," says one former agency official who would not be identified. "Even if Congress decides they want to do something ... it becomes a power play among the committees as to who will continue to get Wall Street support."

One industry expert is wary of any congressional mandate regulating CDSs, saying a global regulator is needed. "We need a global structure, a modern coherent regulatory regime; otherwise, you'll have a patchwork of regulation."

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