UPDATE 2-CME Group may start clearing CDS in Dec-CEO

(Adds details, analyst comment, changes dateline to CHICAGO/NEW YORK)

By Jonathan Spicer and Karen Brettell

CHICAGO/NEW YORK Oct 21 (Reuters) - CME Group (CME.O) expects to launch its clearing house for the $26 trillion credit default swap market in mid-December, as a deadline for dealers to offer clients access to clearing for the contracts comes due, CME chief executive Craig Donohue said on Wednesday.

The exchange has been testing its clearing house with seven or eight CDS dealers and around 10 buyside firms, to prepare for the launch, Donohue said in an interview in Chicago, on the sidelines of the Futures Industry Association conference.

The group is "going through all of the different issues that we have to have them operationally ready to begin clearing trades with us by mid -December," Donohue said. "We're making a lot of progress."

Central clearing, in which the exchange stands between the two counterparties on the contract and assumes the risk of the failure of a trading partner, is viewed as key to removing systemic risks posed by derivative contracts.

American International Group (AIG.N) needed a government bailout in September of last year after it sold hundreds of billions of dollars of protection on risky assets using CDSs, and did not have adequate capital to back up its commitments.

A group of sellside and buyside firms including JPMorgan (JPM.N), Barclays (BARC.L), Deutsche Bank (DBKGn.DE), Morgan Stanley (MS.N) and ten other dealers, in June told regulators that they would offer buyside market participants access to all viable clearing CDS solutions by December 15.

Credit default swaps are used to protect against a borrower defaulting on their debt or to speculate on their credit quality.

ICE Trust, which is part of the IntercontinentalExchange (ICE.N), is the only U.S. clearing house that has begun clearing trades and has been favored by banks clearing their interbank trades.

The company, which has a revenue sharing agreement with dealers, said in September that it expected to offer CDS clearing for buyside clients this month, subject to regulatory approvals.

Regulators have pushed the industry to offer more than one clearing solution.

"It seems pretty obvious that Washington wants competition, they don't want ICE to be the only game in town," said Kevin McPartland, senior analyst at TABB Group in New York.

CME is viewed as likely to win strong support from bank clients that trade CDS, such as fund mangers, as they may benefit from netting margins posted against CDSs with other positions the exchange clears, including futures contracts.

"One of the huge benefits at the CME is the potential to cross margin against futures positions," said McPartland.

CME said last month it had opened its clearing effort to include new fund managers as founding members.

AllianceBernstein, BlackRock (BLK.N), BlueMountain Capital Management, the D.E. Shaw Group and Pacific Investment Management Co, or Pimco, joined Citadel Investment Group, CME's original joint venture partner for the offering.

CME is also continuing talks with large dealers to add as founding members to the venture.

The exchange's decision to drop plans to offer CDS trading, meanwhile, was made after consulting with the participants in the market, Donohue said.

"There are a lot of questions about whether large segments of the over the counter derivatives market can actually be traded effectively in an exchange kind of environment. I'm not sure the market is ready for that right now," he said.