Industry commits to central clearing for credit swaps

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Major banks and brokers involved in the credit default swap industry committed yesterday (19 February) to using EU-based central clearing for their trades, bowing to regulators’ pleas to reduce risk in a business that stands accused of worsening the ongoing financial crisis.

Under pressure from the European Parliament and the European Commission, the main firms active in the credit default swap market agreed to use central, counterparty clearing for “eligible” EU contracts by the end of July. They confirmed their engagement via a letter sent to Internal Market Commissioner Charlie McCreevy.

The letter’s signatories include Barclays Capital, Citigroup Global Markets, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley and UBS, all members of the International Swaps and Derivatives Association (ISDA). The European Banking Federation (EBF), which represents both buyers and sellers in the derivatives market, backed the move.

Credit default swaps have so far been exchanged “over-the-counter” (see background), meaning directly between traders and without any guaranteeing counterparty. The risk of insolvency or that one party will not respect agreements has thus been high, becoming even higher with the financial turmoil.

With a central clearing house, such risks would decrease, because the counterparty would engage in monitoring the reliability of the parties and cover possible defaults through fees paid in advance by the traders.

McCreevy yesterday welcomed the industry’s new commitment. After the failure of self-regulation negotiations in recent months, the commissioner had threatened a legislative intervention to impose European central clearing. A first step has already been taken by the Parliament, which introduced an amendment tabled by the Socialist Group asking for this provision to be included in the review of the Capital Requirements Directive (CRD), due to be voted upon in plenary in April (EURACTIV 05/02/09).

Uncertainty as to the clearing house’s location

However, the private sector’s initiative is not without possible drawbacks of its own. It is not clear which credit default swaps will be subjected to central clearing. In their letter to McCreevy, banks refer to “eligible” contracts, but eligibility criteria have not been set.

Secondly, the agreement creates deep divisions among EU member states about the scope and the location of the clearer. France is pushing for Paris to be chosen as its seat. French Economy Minister Christine Lagarde openly supported a common body for the euro zone. 

This would exclude the UK market, which is the most developed in Europe. The UK is aiming to see the clearer sited in the City. The establishment of more than one clearing house should not to be ruled out. “We wanted the use of central clearing, but it’s up to the industry to decide who is going to do it,” said McCreevy’s spokesman, Oliver Drewes.

Credit default swaps are a particular type of credit derivatives aimed at guaranteeing a creditor against the risk of default or delays in getting back the credit. Their use was unheard of ten years ago, but their market value now lies at hundreds of trillions of euro.

Credit derivatives typically use benchmarks to value a debit. Once the benchmark is reached, the creditor is paid back a certain amount of the credit, even in the absence of a default.

The advantage of credit derivatives is that they allow companies and governments to increase their means of managing risk. On the other hand, if used irresponsibly, they can increase risk at exponential levels, spreading the negative consequences of defaults across the markets.

Establishing a central clearing house is considered a moderate way of reducing systemic risk related to derivatives. Instead of being exchanged privately ("over the counter", according to the jargon), they will be processed through a third intermediary, which will reduce costs and risk, while at the same time raising guarantees.

  • End July 2009: Deadline for use of central clearing by the credit default swap industry.

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