McCreevy Vets Counterparty Clearing Facility for Credit Default Swaps

Heeding the urgent call of European Commissioner for the Internal Market Charlie McCreevy, the derivatives industry has committed to implement the clearing of credit default swaps on a European central counterparty (CCP), pending a more complete review of the whole derivatives area. The commissioner considers that clearing of credit default swaps on a CCP in the EU essential for financial stability and oversight. The International Swaps and Derivatives Association and the European Banking Federation agreed to immediately engage in a dialogue to resolve all their outstanding technical issues.

The associations and nine of the leading dealer firms in credit default swaps have signed letters to Commissioner McCreevy confirming their engagement to use EU-based central clearing for eligible EU contracts by July 31, 2009. Signatories will work closely with infrastructure providers, regulators and European authorities including the European Central Bank in resolving outstanding technical, regulatory, legal and practical issues. These efforts mirror the engagement the industry has made in other jurisdictions in the interests of a globally cohesive regulatory framework.

While he is aware of the many reasons why more of these derivatives are not exchange traded, Commissioner McCreevy has always believed that more derivatives could be standardized. At the same time, there is a far more pressing need to have a central clearing counterparty for these derivatives. This was underlined by the collapse of Lehman. which was a major counter party in the derivatives area. In addition there was also considerable speculation on Lehman's default through the use of credit default swaps, which again increase the counter party risk in regard to these instruments

The commissioner’s remarks come against the backdrop of a growing global consensus favoring a central counterparty for credit default swaps. Recently, Elizabeth King, SEC Associate Director for Trading and Markets, said that a well-regulated and prudently managed central counterparty for credit default swaps has the potential to significantly reduce counterparty credit risks to market participants. In remarks at the Security Traders Association mid-winter meeting, the SEC official emphasized that a CCP can also reduce systemic risks by preventing the failure of a single market participant from having a disproportionate effect on the overall market.

A central counterparty can also facilitate greater market transparency and encourage a more competitive trading environment, she explained, which could decrease transaction costs, improve price transparency, and contribute to an increase in market liquidity.

A global CCP is becoming more likely as a consensus builds that this is an important aspect of market reform. Recently, French central bank chief Christian Noyer endorsed the initiative to create a central counterparty for credit default swaps, calling the initiative crucial to financial stability. Similarly, the European Central Bank welcomes the initiatives to create central counterparties for credit default swaps and expects to see concrete results. Former NY Fed President Gerald Corrigan recently told the House Agriculture Committee that there should be a single dedicated global CCP for credit default swaps.

Late last year the Fed, SEC and CFTC entered into a Memorandum of Understanding regarding central counterparties for credit default swaps, thereby providing something of an anchor for such focus as it applies to credit default swaps and OTC derivatives more generally. Further, as pointed out by Ms. King, in recognition of the need to strengthen the oversight and the infrastructure of the OTC derivatives market, in November the President's Working Group on Financial Markets announced a series of initiatives. One of these initiatives is the development of one or more central counterparties for credit default swaps, for which recent events have underscored the need.

In essence, the CDS is a deceptively simple financial instrument in which counterparty A (the seller of credit protection) receives a fee from counterparty B (the buyer of credit protection) in exchange for protecting counterparty B against a decline in credit worthiness of a loan or an asset-backed security. If the creditworthiness of the security declines the buyer of protection gains and the seller of protection loses. Needless to say, in a volatile financial market environment in which credit quality is falling and the risk of default is rising, the counterparty risk management process becomes challenging.