All Clear

Can the U.S., the U.K. and Europe cooperate on CDS clearing?


After months of wrangling, European commissioner for internal market and services Charlie McCreevy has won a fierce battle of wills with the leading global dealers of credit default swaps, the derivative contracts that insure against corporate defaults. The instruments trade in over-the-counter markets. McCreevy says central clearing of CDSs is “particularly urgent” to restore market confidence, because the contracts can be traded between investors without a monitor making sure the party issuing insurance on the underlying security has the resources to cover potential losses if a default occurs. The result: unchecked risk-taking and mutual distrust between buyers and sellers, leading to crises such as the meltdown of insurer American International Group.

On February 19, nine of the largest CDS dealers — Barclays Capital, Citigroup Global Markets, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC Holdings, JPMorgan Chase & Co., Morgan Stanley and UBS — bowed to McCreevy’s demands to use a central clearinghouse in the European Union to process what the commissioner referred to in a statement as “systemically relevant” credit default swaps. The Bank for International Settlements estimates that the underlying value of CDSs accounted for $57 trillion of the $684 trillion global derivatives market as of June 2008. The firms also said they would work closely with clearinghouses, exchanges, regulators and the European Commission to resolve technical, legal and regulatory issues by the end of July.

Regulators in Europe have been slower to target CDS clearing than their counterparts in the U.S., but they have been quick to condemn American proposals that could infringe on the E.U.’s regulatory jurisdictions. Indeed, the urgency of McCreevy’s insistence on a European provider increased in late January, when Minnesota Democratic Congressman Collin Peterson introduced a bill that proposed that all CDS transactions be cleared — unless exempted by the U.S. Commodity Futures Trading Commission — by a clearinghouse regulated by the CFTC or the Securities and Exchange Commission. The final bill was amended to include sufficiently regulated foreign clearinghouses too.

The world’s top stock exchanges and clearinghouses applaud the move. Spurred by the lure of increased market share, executives of exchanges in Frankfurt, London and Paris responded with a flurry of competing announcements. London-based LCH.Clearnet Group, which made a groundbreaking foray in December with the launch of Bclear, the world’s first operational CDS clearing service, in conjunction with NYSE Liffe (NYSE Euronext’s derivatives business), said it plans to set up a central euro-zone clearinghouse in Paris by the end of the year. Bclear’s effectiveness is still an open question, however. As of late February volume was nearly nonexistent because of problems with integrating Bclear’s software into the banks’. Frankfurt-based Eurex, a joint venture of Deutsche Börse Group and SIX Swiss Exchange, is also working on a clearing solution for CDS contracts. Eurex, the world’s second-largest derivatives exchange by volume, behind the Chicago Mercantile Exchange, may have a home-field advantage in the fight. “We have the most significant clearing infrastructure in Europe, and there is a natural benefit in leveraging it for this asset class,” says Thomas Book, the Eurex board member in charge of clearing. Atlanta-based IntercontinentalExchange, or ICE, also plans to begin clearing European CDSs by July through ICE Trust Europe, to be based in the U.K. Even CME Group, the world’s largest futures exchange, is seeking approval to open a European credit derivatives clearinghouse and a London-based platform for CDS clearing to complement counterparty clearing services it plans to launch in the U.S.

Clearing CDSs through nationally regulated houses promises to be complex and politically charged. Regulators in the U.S., the U.K. and Europe reiterated in February that they are working toward information-sharing agreements and cross-border standards for CDS clearing platforms. Anthony Belchambers, chief executive of the London-based Futures and Options Association, says that without mutual recognition across regulatory jurisdictions, distrust will persist.