Friday, January 30, 2009

Credit Swaps Overhaul Planned for March as Dealers Curb Risks

By Shannon D. Harrington on Bloomberg:

Dealers plan to overhaul credit- default swaps in March to curb risks in the $28 trillion market, making the derivatives more like bonds and creating a committee that will arbitrate disputes.

For the first time, the market will have a committee of dealers and investors making binding decisions that determine when buyers of the insurance-like derivatives can demand payment and could influence how much they get, industry leaders said yesterday at a conference in New York. Traders also will revamp the way the contracts are traded, requiring upfront payments to make them more like the actual bonds they’re linked to.

The changes are part of a broader effort to increase transparency, mitigate the risk of cascading failures and standardize the way bilateral contracts are traded and disputes are resolved. They’ll also allow dealers to process derivatives through a clearinghouse, heeding the call of regulators following the September failure of
Lehman Brothers Holdings Inc., one of the largest credit swaps dealers.

“You cannot run a clearinghouse without making sure the clearinghouse is always flat,”
Athanassios Diplas, global head of the counterparty portfolio management group at Deutsche Bank AG, said during a panel discussion at the conference, which was hosted by Markit Group Ltd., a data provider and owner of benchmark indexes in the privately traded market.

Credit-default swaps are derivatives based on bonds and loans that were created to protect debt holders against default. The contracts, now commonly used by traders to speculate on corporate creditworthiness, 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.

Contracts typically are traded under a standard set of terms that determine, among other things, how they’re settled if the underlying borrower defaults.

Regulatory Pressure
The Federal Reserve Bank of New York increased pressure on the banks to make the changes following the September bankruptcy of Lehman. The overhaul is intended to coincide with a so-called roll in March, in which the market shifts to a new maturity date for contracts.

Regulators are prodding dealers including Deutsche Bank, JPMorgan Chase & Co., Barclays Plc and Morgan Stanley to move trading to a central clearinghouse that would back the trades, reducing the risk that the collapse of one dealer would trigger a wave of losses and cause others to fail.

Intercontinental Exchange Inc., Chicago-based CME Group Inc., Eurex AG and NYSE Euronext’s Liffe derivatives market are competing to clear credit-default swaps.

Protection Costs
In one of the most noticeable changes for traders, those who buy protection will pay an upfront fee depending on current market prices, and then a fixed $100,000 or $500,000 annual payment for every $10 million of protection purchased. Now, upfront payments are only required for riskier companies, and the annual payment, or coupon, on most contracts is determined by the daily market level.

The change will simplify trading, reduce large gaps between cash flows that can amplify losses, and make the derivatives more like the bonds they’re tied to, said
Jason Quinn head of U.S. high-grade derivatives trading at Barclays Capital in New York.

The industry committee will make binding decisions such as when a borrower has defaulted and protection buyers can demand payment. They’ll also resolve disputes over which bonds are covered by the contracts. Those decisions may affect the size of the payments protection sellers must make.

Few details were discussed on how members of the committee will be selected, though it will be balanced between dealers and investors, with members publicly disclosed.

“It only works if people believe in it,” said
James Hill, managing director in credit trading and structured credit products at Morgan Stanley.

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