Risk Management

SEC Opens Door to Centralized Credit-Default Swaps

The action should curb the risk of CDS-related disruption in the financial markets, the Securities and Exchange Commission thinks.
David KatzDecember 23, 2008

In an attempt to make what it sees as the shadowy dealings of the credit-default-swap market clearer to the outside world, the Securities and Exchange Commission today approved temporary exemptions that allow at least one firm, London-based LCH Clearnet Ltd., to operate as a central counterparty for the swaps.

The temporary exemptions will enable central counterparties like LCH.Clearnet and some of their participants “to implement centralized clearing quickly,” according to the commission. Further, the SEC thinks the action will provide it with time to review the counterparty’s operations and assess whether registrations or permanent exemptions should be granted in the future.

The commission gave no details about the exemptions, elaborate on whether other counterparty groups could qualify for them, or say what conditions counterparties had to meet to qualify for them. An SEC spokesperson had not returned a call by CFO.com as of presstime.

LCH.Clearnet is a leading central-counterparty group in Europe. It clears a range of asset classes, including stocks, exchange-traded derivatives, and a variety of swaps. Typically, a central counterparty sits in the middle of a trade and assumes the counterparty risk involved when two parties trade. When the trade is registered with the central counterparty, it’s legally bound to ensure the financial performance of the deal. If one of the parties fails, the counterparty steps in.

In such arrangements, the central counterparty collects collateral from its members. If they fail, the collateral is used to fulfill the central counterparty’s obligations.”Well-regulated central counterparties should help promote stability in financial markets by reducing the counterparty risks posed by the default or financial distress of a major market participant,” the SEC said in a release.

In turn, that should curb the risk of CDS-related disruption in the financial markets, according to the release. The use of counterparties “should also promote operational efficiencies and transparency, which are lacking currently in the over-the-counter market for credit default swaps,” the commission said in its release.

Credit default swaps — the unregulated derivatives that are supposed to offer their buyers a payout if the company against which they’re written defaults or goes bankrupt — were, until recently, hailed by many as a valuable financial innovation. In fact, the notional value of credit-default swaps soared to some $62.2 trillion in 2007 from $34.4 trillion in 2006, according to the International Swaps and Derivatives Association.

But the bankruptcy of Lehman Brothers, a major issuer of credit default swaps, combined with the government takeover of AIG, which had covered more than $440 billion in bonds with credit default swaps, has raised serious concerns about the default of the default swaps themselves.

The President’s Working Group on Financial Markets, led by Treasury Secretary Henry Paulson, has called the installation of central counterparty services for credit default swaps a top priority, according to the SEC. “Today’s announcement is an important step in our efforts to add transparency and structure to the opaque and unregulated multi-trillion dollar credit default swaps market,” said SEC Chairman Christopher Cox.

“These conditional exemptions will allow a central counterparty to be quickly up and running, while protecting investors through regulatory oversight,” Cox said. “Although more needs to be done in this area legislatively, these actions will shine much-needed light on credit default swaps trading.”