Federal Reserve Unsuccessful in Prodding Swaps Dealers To Agree With Clearinghouse Goal

Bloomberg has a nice piece of journalism co-written by Shannon Harrington and Matthew Leising.  It helps illuminate the behind the scenes quagmire between regulators and CDS (credit default swaps) investors to lower risk in the $25 trillion CDS market (yes, trillion with a T).

Many of the big players in the market (many of which are hedge funds) refuse to agree to specific goals before the Federal Reserve Bank of New York's March 1 deadline, in which they must define the industry's process by which they will move swaps through clearinghouses.  These talks are currently "private" or behind closed doors.

The New York Federal Reserve Bank was "prodding" (NYFRB "prodding" is probably something close to what most people consider a love smooch) Goldman Sachs, JPMorgan Chase, and Deutsche Bank AG and other swaps dealers into clearing 90% of the eligible trades by 2009.  The investment  banks' clients are fighting against this (clearing trades) because it would cost them more.

After the sudden collapse of AIG and Bear Stearns and the bankruptcy of Lehman Brothers (in other words after all the damage had been done) the Federal Reserve "demanded" the industry start clearing the derivatives trades.  Although asset managers somewhat  backed broader use of clearinghouses, they wanted assurances that clearing trades would also come with some bankruptcy laws protecting the trades. They are also worried about extra collateral costs.  An example the Bloomberg article gives is hedge funds often use trades that take advantage of "price dislocations" between index contracts and swaps on companies included in the index. Prime brokers will demand collateral on the net amount at risk from offsetting trades.

The problem (supposedly) is cash can get tied up in one part of the trades, affecting other trades, and here I will just quote directly from Harrington and Leising's story:

"If one leg of the trade were required to be cleared, while the other contracts aren’t eligible, fund managers may be forced to increase the amount they have to post, tying up cash, the people said.

The New York Fed has led regulators including the U.S. Securities and Exchange Commission, the Commodity Futures Trading Commission, the U.K.’s Financial Services Authority and Germany’s Federal Financial Supervisory Authority in seeking increased transparency and less risk from over-the-counter derivatives markets. Some $605 trillion in contracts were outstanding at the end of June 2009, according to the Bank for International Settlements.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on or hedge a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements."

In essence credit default swaps (my words here) are a type of insurance which people can buy, which pays if a company (or sometimes a country's government) doesn't pay off its debts (maybe debts on bonds or loans).  Derivatives ideally are used to "hedge" against risks or protect from extreme downsides.  There are two leading clearinghouses now, one in Chicago and one in Atlanta mostly involved in contracts tied to credit indexes.

There are ongoing negotiations between the New York Federal Reserve (NYFRB). The negotiations participants include 15 dealers, 9 investment firms, and 3 trade associations. They are trying to resolve obstacles to a higher percentage of swap contracts being traded through clearinghouses.  The New York Fed, PIMCO, and other negotiation participants declined to comment at this stage.

The situation (with negotiations) is probably summed up best by the Chief Operating Officer of BlueMountain hedge fund, Samuel Cole, who I quote directly from the Bloomberg article here:

“The dealer community may be filibustering to protect its oligopoly and not seriously engaged in working with the buy side to develop a clearing solution,”

In other words, dealers are making plenty of money now, and have power in the market, and want things to stay status quo, even if the rest of us have to suffer.