EU Credit Default Swaps Begin Clearing Through Central Counterparties

Credit default swaps relating to European entities and indices based on these entities have begun clearing through central counterparties regulated in the EU. This measure is designed to reinforce financial stability by ensuring better risk management for European credit default swaps and comes in response to Commissioner McCreevy's earlier call to reduce the risks inherent in this market. Credit default swaps are financial products designed to insure the buyer against losses caused by a credit event, such as a default, affecting a given entity, and until now had been managed bilaterally between buyer and seller.

In response to the Commission's call for central clearing of credit default swaps, ten major dealers committed to clear these instruments on European reference entities, and indices based on these entities, through one or more central counterparties. The Commission has set up a working group, involving dealers, the buy-side, such as banks and funds, central counterparties and regulators, to monitor the orderly roll-out of this commitment.

The Commission welcomes the fact that, through ISDA, dealers have developed the standards necessary to allow central clearing for European credit default swaps, in particular standards for the treatment of the restructuring credit event incorporated in the so-called "Small Bang" Protocol, to which the vast majority of market participants have already adhered. The Commission also welcomes the considerable efforts made by the central counterparties to implement these standards so as to offer a solution by the set deadline.

Two European central counterparties, ICE Clear and Eurex Clearing, have already obtained the necessary regulatory approvals and are now offering their services, while a third, LCH.Clearnet SA, is expected to follow by year end. The Commission, therefore, expects that dealers will live up to their commitment and will start using all available central counterparties for all eligible trades.

The Commission will monitor the migration of credit default swaps onto central counterparties and will take account of the progress made by market participants in this area when formulating its policy orientations for OTC derivatives in general. The Commission intends to publish these policy orientations by the end of October 2009, as announced in its July 3 communication on ensuring efficient, safe and sound derivatives markets. To this end, the Commission is currently running a public consultation; and will also organize a high-level conference on derivatives in crisis in September.

Since central counterparties constitute an essential post-trading infrastructure, high supervisory standards are indispensable to ensuring that they have in place proper risk management procedures. However, in order to be able to offer their services on an EU-wide scale, central counterparties had to undergo multiple scrutiny and obtain multiple authorizations. In view of the recommendations recently agreed to by CESR and the European System of Central Banks and with regard to a proper functioning of the single market, the Commission will consider ways to facilitate this process.

Clearing is the process by which obligations arising from a financial security are managed over the lifetime of the contract. Until now, credit default swap trades, like most OTC financial derivatives, are predominantly cleared bilaterally between two contracting parties. A central counterparty is a service providing clearing at central market level. The CCP steps into the middle of each trade, so as to become the buyer to every seller and the seller to every buyer.

From its central position, the CCP's main business is therefore to manage the risk in that market. ISDA praised the commitments made to the European Commission by major market participants toward central clearing of credit default swaps in Europe. Recently, ISDA and the industry have successfully implemented a series of highly significant measures to standardize the way in which credit default swaps are traded and settled. These changes have increased market transparency, robustness and confidence and are key to the success of central clearing in Europe within the deadline set for dealers.

ISDA and its members understand, however, that additional work remains to be done. The industry is engaged in ongoing efforts toward clearing all eligible credit default swaps through a central counterparty.

The major market changes ISDA has introduced over the past several months range from the standardization of trading conventions, such as coupons and effective dates, to the treatment of restructuring as a credit event in certain key markets, to changes in the way transactions are handled post-trade and the incorporation of a global market-standard settlement mechanism into standard CDS trades.

Parallel efforts to reduce the body of existing transactions, increase the use of electronic processing and tighten up collateral practices have had a major impact on the ability of firms to service their outstanding trade populations and better manage their risks. As a corollary to these initiatives, ISDA has made freely available a standard pricing model for credit default swap transactions. All of these measures have facilitated the greater standardization of trade terms and processes without sacrificing the flexibility and utility of the bilateral credit default swap contract.

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