(Adds comment from Nasdaq)
By Ciara Linnane and Karen Brettell
NEW YORK, Oct 6 (Reuters) - The New York Federal Reserve will host a meeting with banks and institutional investors on Tuesday to discuss establishing a central counterparty for the global credit default swap market.
Politicians and regulators have clamored for improved oversight of the $55 trillion over-the-counter market, widely blamed for some of the financial sector’s recent problems.
Industry players agreed with the Fed and other regulators in July that a “robust central clearing infrastructure” is needed for OTC credit derivatives, the Fed said.
“This will help reduce systemic risk associated with counterparty credit exposure and improve how the failure of a major participant would be addressed,” it said.
The statement came after U.S. business television channel CNBC reported the Fed was planning talks with the Chicago Mercantile Exchange, or CME, and the Intercontinental Exchange, or ICE, on the creation of a CDS exchange. The companies declined to confirm the report, although they said they would be willing to participate in any initiative.
“Serious concerns are now emerging about the ability of counterparties of these contracts to actually meet their performance obligations,” CME Chief Executive Craig Donohue told the Council of Institutional Investors Fall conference.
“There’s clearly a lack of confidence in the functioning of that market,” he said.
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.
The collapse of major counterparty Lehman Brothers LEHMQ.PK last month brought fresh urgency to the calls for rules to improve the transparency and safety of the market.
Joseph Mecane, executive vice president and chief administrative officer for U.S. Markets at NYSE Euronext, told Reuters a CDS exchange is “inevitable.”
“The biggest issue is counter-party risk, and a central counterparty will solve that,” he said. “There could be competing exchanges with a central clearing house, like in equity markets.”
It is not yet clear what form a New York Fed-backed central counterparty might take, although 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 by the end of the year.
Separately, a CME spokesperson said the exchange “can be operationally ready to clear CDS in a few weeks.”
NYSE Euronext’s Liffe unit has said it will launch its BClear OTC facility in the fourth quarter.
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. Gov. David Paterson has said the state will start regulating CDS contracts that can be classified as insurance, which he estimates form 20 to 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,.
“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,” said Bob Pickel, chief executive of trade association the International Swaps and Derivatives Association.
He rejected criticism that CDS contributed to imprudent lending by banks in the subprime sector. “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,” Pickel argued.
Still, the head of regulation for the New York Stock Exchange, Richard Ketchum, told Reuters that CDS regulation “needs to go further.”
Chris Concannon, executive vice president of transaction services at Nasdaq OMX Group, agreed. “There is a strong desire among not only the governments, but also the trading community, for a central counterparty to step up to certain products, CDS being the one everyone is focused on.”
Massachusetts Democratic Rep. Barney Frank said Monday he believes the lack of regulation of CDS was behind the recent financial crisis. “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] (Additional reporting by Jonathan Spicer in New York, James Kelleher in Chicago and Svea Herbst in Boston; Editing by Dan Grebler)