Think bigger on credit swaps, federal regulators urged

The formation of a clearinghouse for the murky credit default swaps market appears just months away now that two derivatives exchanges have moved closer to becoming a reality.

But analysts said that while a guarantor of the quasi-insurance contracts on bonds would disperse risk and increase transparency in the $55 trillion market, federal regulators aren’t thinking big enough. Some other types of derivatives will still have no clearinghouse to provide backing for over-the-counter contracts, leaving participants in these trillion-dollar sectors exposed if one of the two parties can’t meet its obligations.

“Who’s to say the next big crisis won’t involve commodity or currency swaps?” said Henry Hu, a law professor at the University of Texas School of Law in Austin, who testifies regularly before Congress about derivatives. “If we really care about transparency, we ought to care about all over-the-counter derivatives.”

A clearinghouse uses deposits from all participants to backstop potential losses. It spreads the risk among all members rather than leaving it concentrated in just the two parties to an agreement.

Some clearinghouses also offer electronic-quote platforms to make prices and volume more transparent.

Craig Pirrong, a finance professor at the University of Houston, said that a single clearinghouse for the entire $600 trillion derivatives market would do more to address risk and inefficiencies than a guarantor for just one of its sectors.

For example, a dealer facing potential losses in two types of derivatives markets — say, currency and credit default swaps — would present a greater risk profile than if he were involved in just one of those sectors. A credit default swap clearinghouse would capture the risk faced by the dealer in that market alone.

‘STARRY-EYED’

“People are a little starry-eyed about how the credit default swap solution is going to work,” said Mr. Pirrong.

Mr. Hu and Mr. Pirrong said that they don’t foresee any effort in Congress or among regulators to try to extend the clearinghouse concept to the entire derivatives market in the near future.

“It may take a scandal or a firm’s collapse,” Mr. Pirrong said.

The International Swaps and Derivatives Association Inc. of New York, an influential group of derivatives dealers, hasn’t yet considered the merits of a single derivatives clearinghouse, group spokeswoman Louise Marshall said.

Another limitation of the clearinghouse will be that participation is voluntary, so dealers can continue to make over-the-counter agreements outside its purview.

But Richard R. Lindsey, president and chief executive of New York-based Callcott Group LLC, said that market forces will likely push dealers to participate.

“If nothing else, people have learned in the last year that counterparty risk matters a lot,” said Mr. Lindsey, former head of The Bear Stearns Cos. Inc.’s clearing unit and ex-director of the Securities and Exchange Commission’s market regulation division.

The push for regulation of credit default swaps, which SEC Chairman Christopher Cox has described as “urgent,” stemmed from their role in the downfall of insurer American International Group Inc., as well as Bear Stearns and Lehman Brothers Holdings Inc., all of New York. AIG almost collapsed last month after it issued $440 billion in swaps and couldn’t back up its promises to cover debt defaults.

Other types of derivatives include swaps involving currency, commodities, interest rates and equities. Portions of the interest rate and equities swap markets already have clearinghouses.

Four teams of firms have applied for recognition as credit default swap clearinghouses. Regulators indicated last month that they may pick more than one.

CME Group Inc., a Chicago-based derivatives exchange, and Citadel Investment Group LLC, a Chicago-based hedge fund firm, reached a milestone last month when their planned clearinghouse passed internal testing.

The system could be ready to roll in January.

Another applicant, derivatives exchange operator IntercontinentalExchange Inc. of Atlanta, recently acquired The Clearing Corp., a dealer-run company in Chicago. ICE got a commitment for more capital for its clearinghouse from dealers including Credit Suisse Group Inc. of Zurich, Switzerland, and The Goldman Sachs Group Inc. of New York.

Neil Roland is senior reporter at sister publication FinancialWeek.