CDS Regulation Battle

Article excerpt

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 counter-party 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. …