Fed's Bernanke: Swaps market needs improvement

By Joanne Morrison

ARLINGTON, Va (Reuters) - The $62 trillion credit default swaps markets and other off-exchange financial instruments are not managed as well as they should be, Federal Reserve Chairman Ben Bernanke said on Tuesday.

"The infrastructure for managing these derivatives still is not as efficient or reliable as that for more mature markets, as was evident last summer, when a surge in CDS trading volume greatly increased backlogs of unconfirmed trades," Bernanke said in remarks to a mortgage lending forum sponsored by the Federal Deposit Insurance Corp.

Bernanke's comments come as CDS dealers work on a number of systems to reduce credit risk, diminish backlogs and improve processing for these highly complex markets that are mostly unregulated.

The issue was heightened with the near-collapse of Bear Stearns earlier this year, as regulators and market participants feared the firm's CDS exposure was broad-based and would cause systemic risks in the market.

"The potential vulnerability of the financial system to the collapse of Bear Stearns was exacerbated by weaknesses in the infrastructure of financial markets," Bernanke said.

"Bear Stearns' counterparties on thousands of over-the-counter derivatives contracts would likely have had serious difficulty promptly determining their vulnerability to counterparty losses," he added.

CDS MARKET BALLOONS

The complex and privately negotiated credit default swaps market has ballooned over the past decade to more than double the value of the U.S. stock market. These customized transactions in this opaque market are used by companies as an insurance policy to cover losses to banks and bondholders when companies fail to pay their debts.

At present, a group of the major CDS dealers, accounting for roughly 90 percent of market activity, is working with the Federal Reserve Bank of New York to establish a clearinghouse.

In his remarks to the banking group on Tuesday, Bernanke did not directly support the clearinghouse.

"We are very supportive of this effort to have derivatives clearinghouses," said JPMorgan Chase & Co Chief Executive Officer Jamie Dimon, speaking before the conference. His firm is part owner of the clearinghouse being developed.

"We think clearinghouses and exchanges generally reduce operational risk and all other forms of risk," Dimon said.

Institutions involved in the plan include Goldman Sachs Group Inc, Citigroup Inc, Deutsche Bank, JPMorgan Chase & Co, UBS, Credit Suisse, Merrill Lynch & Co Inc, and Bank of America Corp.

Plans for the clearinghouse are still being mapped out, and industry experts caution that there are some risks in centralizing credit risk into one entity.

The effort has grabbed the attention of lawmakers, including Sen. Charles Schumer, a Democrat from New York, who on Tuesday cautioned that this central clearinghouse needs to be regulated by the Federal Reserve rather than the agency that regulates clearinghouses for futures markets.