Credit derivative brokers plan clearing house

By Jane Baird

VIENNA, April 17 (Reuters) - A group of at least 10 major credit derivatives brokers are working on a plan to create a central clearing house that would take direct exposure to counterparty risk, according to a Deutsche Bank executive.

"It would help us take a lot of risk out of the system," allowing banks to trade without the fear that the default of a dealer could cause a shock to the market, Athanassios Diplas, Deutsche's chief risk officer for global credit trading, told the annual meeting of the International Swaps and Derivatives Association (ISDA) on Wednesday.

The proposal comes after JPMorgan (JPM.N) agreed to buy Bear Stearns BSC.N at a cut-rate price last month as the investment bank was finding it difficult to raise short-term funding. In the derivatives market, brokers and investors were refusing to approve transactions that involved passing on underlying default risk to Bear, bankers said.

Bank executives and analysts have expressed concerns that the default of a major derivatives broker could lead to a chain of counterparty failures and defaults.

The proposed central clearing house would probably require counterparties in credit default swaps (CDS) to put up collateral as well as initial margin to cover any decline in market value, an amount that would be adjusted regularly as spreads widen or tighten.

The group of brokers would contribute to a guarantee fund for the clearing house to cover potential losses from counterparty defaults.

MORE RISK OR LESS RISK

Proponents of the plan say that the netting of multiple brokers' positions on both sides of CDS would leave the clearing house with a small amount of actual exposure to the risk of defaults and that it would collectively require a smaller amount of reserves to cover counterparty risk than the amounts added together that the dealers currently must set aside.

The clearing house would also reduce risk by requiring an initial margin from each dealer in a trade, which dealers do not now typically require of each other.

But critics of the plan said a clearing house might end up concentrating risk, not reducing it in the system.

Riccardo Rebonato, global head of quantitative research for Royal Bank of Scotland, drew an analogy with ratings agencies. "Rather than have thousands of investors doing due diligence, why not concentrate that in the ratings agencies," he said. "It amounts to a concentration of risk."

The plan is an initiative of dealers, not regulators, said Patrick M. Parkinson, U.S. Federal Reserve deputy director in the research and statistics division.

"It's important to take a long, hard look at how counterparty risk would be managed" by the clearing house, he said at a media briefing. "When risk is being concentrated, there are important questions that have to be asked."

The group of dealers using the clearing house will not necessarily include even all 18 major brokers in CDS.

"Admission criteria to the club will be strict," Deutsche's Diplas said. "We don't want people to come in that are not properly capitalised."

The clearing house also would be limited to taking only simple swaps transactions, while the brokers would continue to handle more complex trades in the market.

"Our first effort will be focused on index products," he said, and single-name CDS would be added in subsequent months.

The group is devoting a lot of effort to working through issues such as how much capital would be needed, how risk would be treated, and how margins would be posted, he said.

"We will be taking very measured steps along the way," Diplas said. "We are not going to jump into this unless we know it's going to work."

Thomas Jasper, chief executive officer of Primus Financial Products, questioned whether the clearing house would get off the ground.

"I'm a sceptic," he told the ISDA meeting, adding that he had heard discussions at ISDA on creating a clearing house for 20 years.

"It is the topic du jour because of concern about regulation regarding counterparty risk," he told reporters. "But there are a lot of complexities around it." (Editing by Brian Moss)