NY Fed to push ahead with CDS market regulation

NEW YORK Oct 6 (Reuters) - The New York Federal Reserve said on Monday it is planning to meet with small banks and institutional investors to discuss establishing a central counterparty for the credit default swap market.

Politicians and regulators have been clamoring for regulation of the $55 trillion over-the-counter market, which has been widely blamed for some of the financial sector's recent problems.

CNBC reported that the Fed is planning talks with the Chicago Mercantile Exchange and the Intercontinental Exchange, or ICE.

The collapse of major counterparty Lehman Brothers (LEHMQ.PK) last month brought fresh urgency to the calls for rules to improve transparency and safety.

Credit default swaps, or CDS, are used to protect against the risk that a borrower will default on its debt, or to speculate on its credit quality.

Critics charge that the rapid growth of the CDS market helped fuel demand for banks to extend loans to people unable to repay their mortgages. They then distributed those loans globally, exacerbating systemic risk when contracts failed.

Massachusetts Democratic Rep. Barney Frank said Monday he believes the lack of regulation of CDS was behind the recent financial crisis. Congress on Friday approved a $700 billion government package to bail out the U.S. financial system.

"We have to step in and impose regulations that will not allow this to happen again," said Frank, who is head of the House Financial Services Committee. See [ID:nN06387796]

It is not yet clear what form a New York Fed-backed central counterparty might take, although a number of initiatives are underway to create a clearing house for swaps.

Clearing Corp, a dealer-owned clearing house, expects to have the required regulatory approvals and systems in place to launch a clearing platform for U.S. and European CDS by the end of the year.

Separately, the Chicago Mercantile Exchange "can be operationally ready to clear CDS in a few weeks," according to a spokesperson.

NYSE Euronext's Liffe unit has said it will launch its BClear OTC facility based on the benchmark European credit derivative indexes in the fourth quarter.

NY STATE PLANS TO ACT

New York State authorities recently said they too are working on a clearing house as part of a broader plan to start regulating the CDS market from January 2009.

New York Gov. David Paterson has said the state will start regulating CDS contracts that can be classified as insurance. He estimated these contracts form 20-25 percent of the market.

The bankruptcy of Lehman Brothers also revived calls to move CDS trading onto an exchange, an initiative that has so far failed to find any traction in the market.

Proponents argue that exchange trading would remove the system risk posed by a counterparty failure, provide price transparency and offer simpler, more standardized settlement of contracts when an issuer defaults.

But banks have previously failed to provide the liquidity needed to support exchange trading, in many cases due to a desire to protect margins they collect from trading CDS privately.

"Exchanges coexist with OTC in other products, but for historical reasons and because of the development of the OTC product it hasn't developed in the credit area," said Bob Pickel, chief executive of trade association the International Swaps and Derivatives Association.

"I think ultimately it's a question for the marketplace to determine whether they need the structure and the standardization that an exchange-traded product provides, or whether they can achieve significant elements of standardization through the OTC product."

Pickel rejected the criticism that CDS contributed to imprudent lending by banks in the subprime sector.

"Our observation is that those poor decisions have flowed through the system and in fact credit default swaps have provided a mechanism for firms to hedge their exposure to those subprime loans and for that they've been extremely effective," he argued.

The head of regulation for the New York Stock Exchange, Richard Ketchum, said the NYSE could play a role in a possible exchange and is open to talks with U.S. and European regulators.

In another sign that the drive toward regulation is gathering steam, the President's Working Group and the U.S. Treasury also said they are consulting with market participants on ways to support unsecured funding markets like the CDS market.

The parties said they are also monitoring clearing and settlement systems and "encouraging further centralized clearing for other financial instruments to bring enhanced transparency and counterparty risk management to those markets." [ID: nN06380577] (Additional reporting by Jonathan Spicer in New York and Svea Herbst in Boston; Editing by Dan Grebler)