A tussle seems to have broken out between the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) over which body should regulate the over-the-counter credit default swaps (CDS) market in the US.
Until the collapse of Lehman Brothers and its domino effect on the rest of the world’s banks, regulators were fairly laconic about tampering with the $62 trillion market. The CFTC voted to exempt swaps from its oversight in 1993 under pressure from lobbyists for Enron, and this exemption was passed as part of the Commodity Exchange Act of 2000. The CDS market grew exponentially after that, doubling nearly every year since the International Swaps and Derivatives Association (ISDA) started to measure them in 2001.
In 2005 ISDA, the Federal Reserve Bank of New York and the UK Financial Services Authority took a leading role in pushing CDS market participants to reduce transaction backlogs which were presenting substantial operational and legal risks for firms. By 2007 this had been alleviated, but there was still no regulatory oversight.
Now the regulators are all over it. In a speech given on 8 October to an SEC roundtable, SEC chairman Christopher Cox said: “It is a market that is completely lacking in transparency, and virtually unregulated.”
He called for Congress to act now to provide for regulator oversight of CDS, saying both the SEC and the CFTC should be given that authority.
But, last week a commissioner from the CFTC said that the CFTC should have the authority to regulate swaps. According to Dow Jones, CFTC Commissioner Bart Chilton, a Democrat, said: “It’s actually the CFTC who I think does have a more direct responsibility for the potential oversight of these; they are risk management tools. They look exactly like futures products.”
There are futures products on CDS – both the CME Group and Eurex have contracts that were launched over a year ago, but the market participants preferred the OTC route. One source says the Tier 1 banks and sell side traders didn’t want to use exchange-based products because they couldn’t make as much money as they did with OTC bilateral deals.
CME launched Credit Index Event contracts on 17 June, 2007, contracts that combine the benefits of OTC swaps with an exchange-traded, centrally cleared and guaranteed product. Only a handful of contracts have since traded..
In March 2007, Eurex introduced exchange-traded credit derivatives contracts based on the well-known iTraxx Index series. The Eurex iTraxx credit futures were designed to closely mimic the risk structure of credit default swaps traded in the OTC market, and are cash settled. There are currently no trades on these products.
Oversight and clearing of OTC CDS took on particular relevance last week when the Lehman CDS settlement, bets on whether or not it would go bankrupt, had to be settled. The settlement, estimated as high as $300 billion, meant that participants had to raise cash in a time when raising cash is extremely difficult. Had the CDS contracts been hedged or speculated upon using futures contracts, the settlement would have been guaranteed by the exchange or clearing facility.
A spokesperson for Eurex says business dried up on CDS early on because there are no market makers: “We started with one but with no support from the sell side liquidity dried up.” The spokesperson does expect that this will change given the current circumstances. “There is a need for and space for futures in this segment,” he says.
Eurex is also planning to launch a clearing service for OTC derivatives in the first half of 2009. Bank-backed derivatives clearing house, The Clearing Corp, is also planning a clearing platform for OTC CDS and says it will be ready by the end of the year.
The CME meanwhile is launching an electronic exchange for CDS in partnership with Citadel, and ICE says it too plans to develop a platform with The Clearing Corp., Markit Group and Risk Metrics (see related stories).