CME may push for credit-default swap protection

Intercontinental Exchange Inc. and CME Group Inc., the two largest U.S. futures exchanges, are considering asking Congress to protect money used to guarantee credit-default swap trades from bank defaults.

The proposal is part of a June 30 International Swaps and Derivatives Association report to regulators and the trade group's members on how to comply with U.S. demands that the two exchanges' swaps clearinghouses expand access beyond banks to hedge funds, energy companies and other investors. The report was shown to Bloomberg News by an ISDA member who didn't want to be named because it hasn't been publicly released.

Banks that sell swaps to hedge funds hold money from the buyers, who forfeit that cash if the trade goes against them. Under current law, that so-called margin money ends up pooled with the bank's other assets if it goes bankrupt or is seized by federal regulators, putting its swap customers in the same fix as its other creditors. The proposals would change bankruptcy and depository laws to allow banks to segregate the swap buyers' money, a system akin to how futures transactions are handled.

"All the firms are placed on an equal footing through this segregation method," said John Jay, a senior analyst at financial-services consulting firm Aite Group LLC in Boston. "It'll give hedge funds more opportunity to trade with more counterparties."

ISDA spokeswoman Cesaltine Gregorio declined to comment on the June 30 report. Atlanta-based ICE spokeswoman Kelly Loeffler and Chicago-based CME Group spokesman Allan Schoenberg wouldn't answer questions about the document.

Systemic Risks

Capitalized by members, clearinghouses act as the buyer to every seller and the seller to every buyer in derivatives transactions, insuring both sides against default by the other. They also allow regulators to watch market positions and prices for signs of systemic risks.

Intercontinental's ICE Trust clearinghouse is only open to banks trading credit swaps with each other; its members include New York-based Goldman Sachs Group Inc. and JPMorgan Chase & Co. and other Wall Street banks. That leaves hedge funds and other investors at risk of counterparty default in their privately negotiated transactions. ICE Trust is working on plans to allow hedge funds and other bank customers access to its clearinghouse. The segregation proposal would expand the pool of potential clearinghouse customers by reassuring hedge funds that their margin money will be protected, which wasn't the case when Lehman Brothers Holdings Inc. collapsed last September.

Hedge Fund Access

CME Group's CMDX clearinghouse, a joint effort with Chicago hedge fund Citadel Investment Group LLC initiated this year, hasn't cleared a credit swap yet. It plans to provide access to hedge funds and other non-bank traders.

The exchanges and the derivatives industry are under pressure from U.S. officials to level inconsistencies among credit-swaps participants. In April, officials at the Federal Reserve Bank of New York said that hedge funds and other investors in the credit-default swap market should receive similar protections from counterparty failures that banks have started to receive as through ICE Trust.

The collapse of Lehman, one of the largest credit-swaps dealers, and last year's U.S. rescue of American International Group Inc. after it made bad bets using credit swaps, convinced U.S. and European officials that they needed to regulate the $592 trillion over-the-counter derivatives market.

Lehman Fallout

Lehman's failure cost its trading partners in the credit- default swap market hundreds of millions of dollars, according to Moody's Investors Service. Its interest-rate swap trades backed by LCH.Clearnet Ltd.'s clearinghouse in London were unwound without incident.

According to Moody's analysts led by Alexander Yavorsky, Lehman's collapse forced the firm's trading partners to replace swaps they had with the failed bank with ones purchased elsewhere, just as their cost soared. Some banks that had swaps with Lehman lost money because they hadn't collected enough collateral, Moody's said.

Since March, ICE Trust has cleared more than $1.3 trillion of the credit default contracts, which pay off if the underlying company reneges on its debt. Credit default clearinghouses being set up in Europe by NYSE Euronext, LCH.Clearnet Ltd. and Eurex AG have either not cleared any trades yet or are not operating.

Speculators

Credit-default swaps were created initially as a way for banks to hedge their risk from loans. They became popular vehicles for hedge funds, insurance companies and other asset managers to speculate on the quality of debt or on the creditworthiness of companies because they were often easier and cheaper to trade than bonds.

The ISDA report was written by 16 member firms. It was sent to the U.S. Commodity Futures Trading Commission, the U.S. Treasury, the European Commission, the European Central Bank and the major over-the-counter derivatives dealers, according to the report.

As part of the plan, ICE has proposed changing the Federal Depository Insurance Corporation Improvement Act of 1991 to ensure that ICE Trust would have the authority to transfer trades of a defaulted clearing member.

ICE also wants the law changed so cleared derivative trades would be treated separately from trades executed without clearinghouse guarantees. Under FDIC rules, all qualified financial contracts such as over-the-counter derivatives must be transferred together or not at all when an insured institution is put under receivership or conservatorship.

The proposed change "would facilitate moving of cleared contracts carried with a failed clearing member to a new clearing member," according to the report.

In the report, CME Group proposes changing the federal bankruptcy code to include credit-default swaps under "commodity contracts." That would give credit-default swap traders the same ability to recover margin and collateral in the event of a bank default as investors in futures contracts.