CDS clearing may need more legal protections-study
NEW YORK, July 8 (Reuters) - Some U.S. and international bankruptcy laws may need to be modified to ensure stronger protection of client funds in central clearinghouses vying for business in the $26.5 trillion credit default swap market, according to a study by market participants.
The study was presented last week to regulators including the New York Fed and tested the ability to reclaim or transfer client collateral that is posted against CDSs at six central clearinghouses in the United States and Europe, in the event of a dealer failure.
The study was made as part of an ongoing industry commitment to reduce risks in the privately traded market. CDS are used to insure against a borrower defaulting on their debt or to speculate on their credit quality.
Some investors took losses when they were unable to reclaim collateral posted against derivatives when Lehman Brothers failed, because the assets became mired in bankruptcy proceedings.
The study found that each clearinghouse would benefit from further legal or regulatory clarity to protect client funds, said a person involved in the study, who declined to be identified because the results have not been made public.
"None of them are unambiguously clear in how current law and regulation would support their clients," he said.
However, each of the central clearinghouses improve on the current bilateral trading agreements, the person added.
A spokesperson for the New York Fed declined comment on the study.
The study ran to more than 150 pages and involved the participation of large players in the CDS market.
ICE, CME
Among those clearing houses examined in the study were the IntercontinentalExchange Inc (ICE.N), which has a revenue sharing agreement with large CDS dealers for its clearing arm, and the CME Group Inc (CME.O), which has a joint venture with hedge fund Citadel Investment Group.
Of these, the study found that the ICE platform offers quite strong protection for clients of U.S. and British institutions using the service, said the person involved in the study.
Clients of European entities, however, face more complexity, particularly in jurisdictions where the treatment of client assets in bankruptcy is less clear, he said.
A spokesperson for ICE declined to comment on the study.
The CME's platform only allows U.S. entities to clear trades through its clearinghouse, though the study participants identified the company's definition of a CDS as a futures contract based on a commodity as a potential issue.
If a member of the CME's clearing effort defaults, this definition could be challenged by another claimant on the defaulted institution's funds, potentially blocking access to the collateral posted on the CDS trade, said the person involved in the study.
Making legislative changes to the U.S. bankruptcy code could add clarity and remove this as a potential issue, he said.
"We believe that CDS products are encompassed within the definition of commodity under the Commodity Exchange Act," said Michael Shore, spokesman for the CME.
ICE is the only clearinghouse to have started clearing CDS, and has cleared $1.3 trillion in notional volumes on CDS indexes.
Other clearinghouses evaluated in the study include NYSE Euronext (NYX.N), London-based LCH.Clearnet, Frankfurt-based Deutsche Boerse (DB1Gn.DE) and German/Swiss exchange Eurex. (Additional reporting by Kristina Cooke in New York, editing by W Simon)
