SEC Official Endorses Central Counterparty for Credit Default Swaps as Global Consensus Grows

Against the backdrop of a growing global consensus favoring a central counterparty for credit default swaps, 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 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.

The SEC official also noted that, in order to facilitate the operation of central counterparties for credit default swaps, late last year the Commission exempted LCH.Clearnet from the requirement to register as a clearing agency. The Commission also provided exemptions to other market participants, including LCH.Clearnet clearing members and broker-dealers. Importantly, she emphasized, the Commission did not exempt these market participants from the antifraud provisions of the securities laws and retains the ability to investigate potential violations and bring enforcement actions. Further, the exemption does not extend to those securities law requirements applicable to broker-dealers that are especially important to protecting funds and securities, ensuring proper credit practices, and safeguarding against fraud.

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.

Regardless of which type of central counterparty for credit default swaps emerges as the industry standard, former NY Fed President Corrigan told the House Agriculture Committee that regulators must satisfy themselves that the risk mitigation features of the CCP have virtually fail safe operational and financial integrity including the capacity to absorb the default of two of its largest members.