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Derivatives industry says tools to manage risk in place

WASHINGTON (Reuters) - While politicians and regulators talk about improving transparency and reducing credit risks in the multitrillion-dollar off-exchange derivatives markets, industry participants have been managing risk on their own.

The credit default swaps industry, which has grown to a $62 trillion market over the past decade, has grabbed the attention of some regulators and lawmakers who fear there is too little information disclosed among firms about risk exposure.

But according to the International Swaps and Derivatives Association, firms have increased collateral for off-exchange derivatives transactions on their own.

The association’s latest survey released in April says that collateral grew by 60 percent in 2007 from a year earlier with some 65 percent of credit exposure for these privately negotiated contracts covered by collateral.

“These mechanisms help to reduce to less than 3.0 percent of notional values the exposures between dealers,” said Robert Pickel, the trade group’s chief executive officer.

The market drew heightened attention in March, when investment bank Bear Stearns BSC.N faced bankruptcy after its holdings in mortgage-backed securities quickly dropped in value.

Even though that firm’s troubles were based on the declining value of its mortgage securities and not its derivatives holdings, some lawmakers and regulators have warned the credit default swaps markets could be the next area of trouble.

Even during a liquidity crisis, the highly sophisticated credit default swaps market has grown, swelling by 40 percent in the latter half of 2007 alone, according to the latest data released by the Bank for International Settlements.

But many off-exchange derivatives experts question whether it is better to allow these markets to function on their own rather than boosting regulation.

“I’ve always been very leery of regulatory efforts in the market structure area to impose a certain model on business transactions,” said Sharon Brown-Hruska, former chairman of the Commodity Futures Trading Commission who now consults for National Economic Research Associates in Washington.

CLEARING PLAN SOUGHT

In the latest development, New York Federal Reserve Bank President Tim Geithner has been meeting with a group of firms representing about 90 percent of credit derivatives trading to develop a centralized clearinghouse, one that will be privately owned and operated by and among the firms that have been meeting with the central banker behind closed doors.

“These changes to the infrastructure will help improve the system’s ability to manage the consequences of failure by a major institution,” Geithner said in a speech on Monday announcing the latest meetings, cautioning that the changes will take time.

According to an industry source, those involved in the meeting include: Deutsche Bank DBKGn.DE; JPMorgan Chase JPM.N; Goldman Sachs GS.N; Citigroup C.N; Credit Suisse CSGN.VX; UBS UBSN.VX; Merrill Lynch MER.N; and Bank of America BAC.N.

The Federal Reserve is not the primary regulator of any of these firms, but the firms own the clearinghouse that would be used for credit default swaps and membership will, at least initially, be limited to these firms.

This clearinghouse, Clearing Corp, is the clearing business of the Chicago Board of Trade and is regulated by the Commodity Futures Trading Commission.

Geithner, who has been meeting periodically with this group of key credit default swaps dealers for the past several years, has maintained that more transparency is needed to better assess credit and default risks in credit default swaps and other off-exchange derivatives contracts because they are interconnected throughout the global marketplace.

But firms have been beefing up their own respective risk management and some industry experts question whether centralizing risk into one clearinghouse will do much to improve the situation.

“It’s not obvious that this is the solution,” said Brown-Hruska, who regulated the country’s biggest clearing corporations while heading the CFTC.

“It creates a single point of failure because it can concentrate risk,” she warned.

Another way to improve transparency would be to establish broader use of exchange-like trading. This would differ from a clearinghouse because a trading platform would offer price transparency without assuming risk and exposure from the parties involved in the private transaction.

Reporting By Joanne Morrison; Editing by Gary Crosse

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