Friday, December 12, 2008

Fed Refuses Banks Request to Limit Credit-Default Swap Clearing

(Bloomberg) -- U.S. regulators are refusing to allow JPMorgan Chase & Co., Goldman Sachs Group Inc. and seven other banks to dictate what credit-default swap trades will be processed by Intercontinental Exchange Inc.’s proposed clearinghouse, said two people with knowledge of the discussions.

The Federal Reserve Bank of New York denied the request for permission to form a committee that would be able to veto the submission of some contracts, according to the people, who asked not to be named because the discussions are private. The Fed wants ICE U.S. Trust, as the clearinghouse is known, to be governed independently of the banks, the people said.

The clearinghouse is part of efforts to impose oversight of the $31 trillion credit-default swap market after the contracts contributed to this year’s demise of Lehman Brothers Holdings Inc. and the U.S. takeover of American International Group Inc. By keeping certain contracts off the clearinghouse, banks would preserve the trading fees they earn from the privately negotiated contracts.

“This has been a sizeable profit generator for banks, and they’re seeing it go away at a time when they can least afford it,” said Mark Williams, a finance professor at Boston University who estimates banks charge between $25,000 and $50,000 to handle a credit-default swap contract on a company in the Standard & Poor’s 100 index.

An ICE spokeswoman, Kelly Loeffler, JPMorgan’s Brian Marchiony and Michael Duvally of Goldman Sachs declined to comment. A Fed spokesman who didn’t want to be named declined to comment.

Banks, hedge funds and other investors currently negotiate credit-default swaps privately. A clearinghouse, rather than a single bank, would be the counterparty to trades and help absorb losses should another dealer fail as Lehman Brothers did.

Competing Plans

The clearinghouse would be funded by its members and add stability to markets by becoming the buyer to every seller and seller to every buyer.

The New York Fed must approve Intercontinental Exchange’s plan, which includes its corporate governance structure, and would regulate ICE U.S. Trust as a member of the Federal Reserve System. Atlanta-based Intercontinental Exchange, also known as ICE, is the second-largest U.S. futures market.

The ICE proposal is competing with clearinghouse plans by Chicago’s CME Group Inc., the world’s largest futures market, and NYSE Euronext and Eurex AG of Frankfurt. CME Group has partnered with Citadel Investment Group LLC to appeal to derivatives traders at hedge funds.

The banks in the ICE plan will capitalize ICE U.S. Trust with more than $1 billion in a fund to cover potential trading losses, according to ICE General Counsel Jonathan Short. In return for that investment, the banks wanted final say over what contracts will be cleared, the people said.

Other Banks

The seven other banks in the ICE plan aside from New York- based JPMorgan and Goldman Sachs are Citigroup Inc., Bank of America Corp. in Charlotte, North Carolina, Zurich’s Credit Suisse Group AG, Morgan Stanley, Deutsche Bank AG in Frankfurt, Merrill Lynch & Co. and UBS AG in Zurich.

Credit-default swaps are contracts that were conceived to protect bondholders against default and are now widely used to speculate on the creditworthiness of companies. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. An increase in the price indicates deterioration in the perception of credit quality; a decline signals the opposite.

The most actively traded contracts in the credit-default swap market are indexes of U.S. and European companies with investment-grade debt ratings. Contracts based on specific companies also trade.

Fighting Regulation

Investment banks have fought regulation of private markets for more than a decade because the lack of transparency typically allows for greater profitability. As much as 40 percent of the profit for dealers including Goldman Sachs and Morgan Stanley was from private over-the-counter transactions, according to fixed- income research firm CreditSights Inc. of New York.

ICE agreed in October to buy the Chicago-based Clearing Corp., which is owned by Goldman Sachs, Citigroup, JPMorgan and inter-dealer brokers ICAP PLC of London and GFI Group Inc. in New York.

That deal secured commitments by the banks to use ICE U.S. Trust, ICE Chief Executive Officer Jeff Sprecher said on an Oct. 30 conference call.

CME Group and ICE have said they are ready to clear credit- default swap contracts once they receive regulatory approval. NYSE Euronext said it will be ready later this month, and Eurex said it plans to begin clearing in the first quarter.

The Fed, U.S. Securities and Exchange Commission and Commodity Futures Trading Commission signed a memorandum of understanding on Nov. 14 that they said will, for the first time, provide broad oversight of the credit-default swap market.

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