Businesses trying to establish the new market include CME Group Inc.; NYSE Euronext Inc.; IntercontinentalExchange Inc. or ICE; Eurex, the derivatives arm of Deutsche Börse AG; and Knight Capital Group Inc. Futures giant CME, with hedge fund Citadel Investment Group LLC,
is offering to create a platform that would clear trading of credit
default swaps by matching buyers and sellers, guaranteeing that both
would have the financial strength to stand behind their trades. Then,
on Oct. 30, ICE announced it agreed to acquire the Clearing Corp. and signed agreements with nine banks, bolstering its position to establish its trading platform.
Initially, it looks like Ben Bernanke's Federal Reserve will oversee
the nascent trading platform. According to ICE officials speaking on a
conference call last week, the exchange sought to design a clearing
model for CDSs that would be subject to Fed oversight, since the
central bank was taking a pre-eminent role in addressing the credit
crisis.
The Fed wants details on how CDSs would be settled by a
clearinghouse, how trades would be processed, what safeguards exist if
a trader or a dealer defaults and how the system will protect against a
financial crisis.
But the SEC also wants to regulate CDSs, as does the CFTC. It's
unclear whether the Fed will maintain its oversight or whether it will
eventually hand it off to one of the other agencies.
The Commodities Futures Modernization Act barred the CFTC from
regulating most swap products in 2000. During the swaps explosion,
neither the CFTC nor the SEC were willing to buck the Bush
administration's deregulation policies. With markets in disarray, both
are fighting for the right to preside over swaps. The CFTC says they're
futures contracts and thus are under its jurisdiction. The SEC says
they're financial instruments with no connection to agriculture or raw
materials futures.
Despite the SEC's recent abysmal performance, Chairman Christopher
Cox has said the agency is prepared to regulate swaps with the same
authority it has over stocks and bonds. The CFTC may argue that at
least one industry proposal for a new platform for settling swap
contracts would give it top duties.
Walter Lukken, the CFTC's acting commissioner, told lawmakers at an
Oct. 14 hearing that current law exempts swaps from regulation and that
"wholesale regulatory reform will require careful consideration." He
should know -- Lukken helped craft the law barring the CFTC from
regulating most swap products when he was a Republican congressional
staffer. Enron Corp., the biggest energy derivative merchant in the
U.S. at the time, lobbied heavily for the exemption, which was
sponsored by then-Sen. Phil Gramm, R-Texas. Now Lukken is conceding
that some regulatory structure is necessary.
Congress could simply merge the SEC with the CFTC. Treasury
Secretary Henry Paulson proposed such a step in March, saying a single
securities and futures regulator would better reflect how deeply
entrenched Wall Street is in many markets. And before the House
Committee on Oversight and Government Reform last week, Cox said he
"strongly supports" a merger.
New York state has moved recently to regulate some CDS contracts
because of their insurance component, proposing that the seller may
have to be licensed as an insurer in New York.
The outcome of the turf war will have practical implications for how
the platform will work. The CFTC and the New York Fed favor a less
regimented clearinghouse platform; the SEC wants a more formal exchange.
The clearinghouse would charge a fee and act as an intermediary that
would guarantee transactions between swaps traders. To make those
guarantees, the clearinghouse would require traders to maintain
sufficient capital in their accounts. That would make it hard to trade
without the money to cover a contract in case of default.
Working with the New York Fed is the ICE, which plans to set up in
New York under Fed authority. Some of the country's biggest banks,
including Goldman, Sachs & Co. and Morgan Stanley,
established ICE. In June it bought Creditex Group Inc., which executes
and processes swaps in the U.S., Europe and Asia. Creditex and
subsidiary Markit Group Ltd. recently liquidated swaps of Fannie Mae, Freddie Mac and Lehman Brothers Holdings Inc. That could give it a leg up in the battle.
CME Group and hedge fund Citadel would not only trade CDSs on a new
platform but also use CME's clearinghouse to clear swaps. CME would get
involved as counterparty in every CDS trade and manage the credit
exposures from the time the trade is made to when the trade is
officially settled. The CFTC now oversees its operation.
NYSE Euronext London-based subsidiary Liffe also plans to process
and clear swaps. The service, announced in July and called Bclear, now
clears equity derivatives trades and would remove counterparty risk by
using LCH.Clearnet Group Ltd. as a central counterparty to all the CDS contracts it processes.
If Congress grants the SEC power to oversee swaps, the agency could
set up several exchanges, similar to the New York Stock Exchange and
Nasdaq.
Stephen Figlewski, a professor of finance at New York University's
Stern School of Business, wrote in a recent paper that the
over-the-counter CDS market needs such an exchange. Clearinghouses "are
too fragile, too loosely regulated and too opaque," he wrote.
There's been resistance: An exchange would reduce the ability to
customize CDS contracts, reducing their profitability. "Trading CDSs on
an exchange will make them much more standardized," says Howard Spilko,
a partner at Kramer Levin Naftalis & Frankel LLP in New
York. Spilko adds that CDSs have specialized terms that go with them
that counterparties need to negotiate. "They're not plain vanilla."
CDSs were toxic partly because they were traded and retraded past
the point of knowing who the original sellers were and their value.
That uncertainty had a snowball effect with each failure. The use of an
exchange provides a middleman for each transaction, so the buyer and
seller are identified. If there is a problem, fallout is limited. Swaps
would be marked to market each day.
Dealers also fret that their lucrative business will be transformed,
with exchanges not only executing but designing their own products.
"Exchanges are not just a utility anymore, they're a competitor," says Bob Paul, a former general counsel to the CFTC now with DLA Piper's alternative asset management team in New York.
It's doubtful, however, that one platform or exchange will be the
sole recipient of so much business. Competition should make it less
expensive for parties to trade. What will be more telling is whether
the desire to concentrate liquidity and have a deep pocket will
necessitate one platform winning out over other exchanges and dealers.
Whichever company is picked must offer what thus far has been absent in
the market for CDSs: transparency and more efficient risk management.
Much depends on how Congress settles its own jurisdictional
squabbles. The turf fights among congressional committees with a claim
to jurisdiction will be fierce. Authority over a giant new trading
platform will bring presiding lawmakers not only power, but offer a new
source of campaign contributions from the financial industry. "It's a
minefield," says one former agency official who would not be
identified. "Even if Congress decides they want to do something ... it
becomes a power play among the committees as to who will continue to
get Wall Street support."
One industry expert is wary of any congressional mandate regulating
CDSs, saying a global regulator is needed. "We need a global structure,
a modern coherent regulatory regime; otherwise, you'll have a patchwork
of regulation."
Regulators looked the other way while credit default swaps grew into a $60 trillion threat to the world's financial system. Now the CDS market is getting plenty of attention, and brawling has broken out over how to regulate it and who should oversee the job.
