The question of who will regulate CDSs remains unanswered, but the Federal Reserve Bank of New York (FRBNY), the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have agreed that CDS trades could be cleared by one or more central counterparties as soon as November or December of this year.
The three potential CDS regulators are reviewing risk management designs and other priorities with a goal of increasing market transparency.
“Where will those positions and funds be held?” asks Gary DeWaal, attorney for brokerage Newedge USA LLC. “We don’t want to do anything that reduces the effectiveness of segregated funds in the United States, that is the paramount issue before the CFTC approves any clearing process.” He explains that CDSs may require CFTC exemptions, much like the CME Group’s ethanol swaps contracts, because they may not be deemed futures.
While DeWaal favors daily mark-to-market and transparent pricing, he is concerned that some of the proposed models would allow direct participation in the markets rather than requiring futures commission merchant (FCM) status. The gate-keeping function that FCMs provide is a critical element to the success of the central counterparty clearing model, he says, and needs to be preserved. “We are the guys responsible, it’s not the clearinghouse,” he says, adding that participants need to meet more than just capital requirements; they need to be registered and meet CFTC requirements for internal controls and risk management and that this vetting process is what makes the centralized counterparty model work.
According to the FRBNY, market participants are currently lowering the number of trades and the notional amounts outstanding by more than $24 trillion through tear-ups, and reducing counterparty credit exposures and operational risk. The initiative was developed in response to a request by ISDA on behalf of major credit derivative dealers, and will be managed jointly by Creditex and Markit.
To facilitate transparency, the DTCC, which recently announced plans to merge with LCH.Clearnet, is scheduled to begin publishing aggregate market data from its database of credit derivatives on a weekly basis beginning in early November. The data will include aggregate stock and weekly trade data, including the levels of both gross and net notional CDS traded on the 1,000 largest CDS reference entities.
Former CFTC Chairman Philip McBride Johnson, who heads prominent law firm Skadden’s derivatives products practice group, believes the CFTC is the most logical fit for CDSs. “The CFTC on two occasions considered regulating swaps as futures because they are structurally the same thing. CDSs are more like commodity options or event options,” Johnson says, who added however that Congress told the CFTC to butt out in the 2000 reauthorization of the agency.
“The CFTC seems to be the logical organization and they have the clearing guarantee already in place. Futures contracts have a priority in bankruptcy, which is a special advantage and the swaps community would be regulated by one organization only,” Johnson says. “Right now you have the state of New York talking about trading CDSs as insurance. You know if the New York insurance commissioner is going to regulate these things, so are the insurance commissioners of 49 other states. Now all of a sudden the swaps community has 50 regulators and they don’t have exclusive reg so it would be 50 plus whatever federal regulator decides to pile on. If I were the swaps community and figure[d] I was going to have regulations anyway, I would want it to be as simple and straightforward as possible.”
Johnson was involved in the legislation that granted the CFTC exclusive jurisdiction of futures. “I am not smart enough to know how much money the industry saved as a result of not having to deal with FERC on energy futures, or agriculture on farm products and the interior on metals but they saved a boatload of money.”
Brian Yelvington, senior analyst for Credit Sights, says the CME Group and joint ICE/The Clearing Corp. proposals are very different. Under the ICE TCC proposal, the company would create a Federal Reserve chartered bank that would serve as the central counterparty clearinghouse. It would operate like an OTC market; margins would be based on the credit quality of the participants and dealers would be regulated by the Fed.
Under the CME proposal, the CFTC is the regulator and the structure is more like a futures trading and clearing environment. While the contracts would not be traded as listed futures, there would be an initial margin, plus margin based on the volatility of the instrument traded and on counterparty risk. The clearinghouse then would constantly adjust margin requirements.
“The big feature that the CME is holding out is that everybody is able to face the clearing party with the same protections and holds everyone to the same standards. It’s not clear in the ICE TCC proposal that everyone will have the ability to face the central counterparty,” he says, and that leaves the problem of excessive leverage for the OTC swaps market to deal with.
While the CME model provides more protections, Yelvington gives the edge to ICE. “The dealers are going to support it and they already have licenses for the Markit indexes,” he says. In either case, having central counterparty clearing would provide an arbiter and standard definition for a credit event.