Fed's Kohn sees CDS clearinghouse risks, benefits

WASHINGTON (Reuters) - A central clearinghouse for credit default swaps would reduce risk, but also concentrate it and proper regulation must be in place, Federal Reserve Vice Chairman Donald Kohn cautioned lawmakers on Thursday.

Kohn said establishing a centralized clearing system for the $62 trillion CDS market would not require action by Congress, but he said it would need regulatory approval.

"A central clearinghouse can reduce risk, but it concentrates risk, so once that risk is adequately taken care of, overseen by a regulator, I think it has all the advantages," Kohn told the Senate Banking Committee.

A group of the largest credit default swaps dealers, accounting for roughly 90 percent of total market activity, has been working with the New Federal Reserve Bank to establish such a clearinghouse.

Those involved in the plan include: Goldman Sachs (GS.N), Citigroup (C.N), Deutsche Bank (DBKGn.DE), JPMorgan Chase (JPM.N), UBS (UBSN.VX), Credit Suisse (CSGN.VX); Merrill Lynch MER.N, and Bank of America (BAC.N) are among those involved.

The clearinghouse is owned by these swaps dealers but it is not yet up and running, but when it is it will be regulated by the Commodity Futures Trading Commission.

"It's critical that that entity exercise appropriate risk management itself, that it has some extra resources so that it can withstand the failure of even its largest participant, and that it have good margining and risk-management procedures in place," Kohn said.

In a separate appearance on Thursday, U.S. Treasury Secretary Henry Paulson praised the effort by the dealers and New York Fed.

"I am pleased that a number of the institutions that account for a significant percentage of (over-the-counter) derivatives trading are working to do this, by recently forming a cooperative and working with the New York Fed ... to create the necessary protocols to bring more transparency and efficiency and reduce counterparty credit risk," he said.

"It is imperative that this cooperative bring standardization not only to dealer transactions but to the broader community of counterparties, including hedge funds," Paulson added.

The credit default swaps market drew attention in March when investment bank Bear Stearns faced bankruptcy and had to be rescued by the Federal Reserve. Even though that firm's troubles were related to the falling value of mortgage-backed securities, some lawmakers and regulators began to worry the swaps market could be the next trouble spot.

The clearinghouse plan has some critics, who warn of the danger of creating one central entity to carry the risk of this massive, opaque and largely unregulated market.

Kohn and Paulson emphasized that market discipline is crucial in reducing risks in the OTC derivatives market.

"Regulation alone cannot fully protect the financial system. Market discipline must also constrain risk-taking," Paulson said.

Kohn agreed.

"If the risk management systems don't work it's their incentive to make them work. I think our job as regulators is to make sure that they are moving in the right direction," he said.

(Reporting By Joanne Morrison;)