By Heather Landy
Special to The Washington Post
Saturday, November 15, 2008
Market regulators agreed yesterday to collaborate on the oversight of credit default swaps, the insurance-like derivative contracts that got American International Group into trouble, and said that at least one clearinghouse for the swaps would be in place by year's end.
Government officials had been pressing Wall Street to develop a central clearinghouse that would become a party to every trade and take on the risk of each contract, helping to absorb any losses stemming from a failure of a major dealer of credit default swaps.
The President's Working Group on Financial Markets, an advisory team chaired by Treasury Secretary Henry M. Paulson Jr., said regulators are conducting on-site reviews of exchanges that submitted proposals to run clearinghouses for the market.
Meanwhile, the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission have signed a memorandum of understanding in which they pledged to share information to promote consistent regulation.
"The virtually unregulated over-the-counter market in credit default swaps has played a significant role in the credit crisis, including the now $167 billion taxpayer rescue of AIG," SEC Chairman Christopher Cox said in a statement. "Bringing transparency to this market is vitally important."
The private nature of credit derivatives contracts has made it impossible to precisely measure the size of the market. Estimates within the industry range from about $35 trillion to $55 trillion.
Credit default swaps were developed about a decade ago as a way for bondholders to protect themselves against defaults by borrowers. The market exploded as investors started buying and selling the credit protection without ever owning the underlying bonds.
The September failure of Lehman Brothers generated anxiety for the credit derivatives market on two fronts. Investors were left worrying whether they would suffer losses on contracts in which Lehman was their counterparty, and holders of protection against a Lehman default were concerned about whether all their claims would get settled.
Having a well-regulated intermediary, or "central counterparty," can reduce systemic risks and "be a catalyst for a more competitive trading environment that includes exchange trading" of credit default swaps, the President's Working Group said in its statement yesterday.
CME Group, Intercontinental Exchange, NYSE Euronext and Eurex are proposing to run clearinghouses that would back credit default swap trades and reduce the risk of concentrating exposures to any one counterparty.
The International Swaps and Derivatives Association, which represents about 850 firms involved in over-the-counter derivatives, endorsed calls by the President's Working Group for better management of risk in the credit default swap market.
"ISDA is committed to working with regulators and industry to ensure the OTC derivatives markets continue to play their important role in allowing companies and investors to manage risks, which is more important than ever in these turbulent markets," ISDA Executive Director Robert Pickel said.