Tuesday, March 31, 2009

Dinallo adds to watchdogs' calls for compulsory central clearing of CDS

In the Financial Times by Aline van Duyn and Joanna Chung:

Eric Dinallo, New York's insurance industry regulator, has added to calls by US regulators to make it compulsory for trades in the $28,000bn credit derivatives market to be cleared centrally.

Mr Dinallo said credit default swaps (CDS) - the most common type of credit derivative - were the major cause of the collapse of insurer AIG.

The damage caused was partly the result of a decision in 2000 to exempt CDS from state bucket shop laws, introduced after the 1907 financial crisis which prohibited betting on securities without some stake in the underlying asset.

"AIG Financial Products, the unit that sold almost $500bn of them [CDS], may therefore be viewed as the biggest bucket shop in history," he writes, adding that this experience meant regulators should once again revert to rules requiring capital to be held against insurance contracts such as credit derivatives, which pay out in the event of default.

"Credit default swaps must be regulated and sellers must be required to hold sufficient capital," Mr Dinallo writes.

"That will make credit default swaps more expensive, but it will also mean that the guarantee has real value."

Mr Dinallo, whose department regulates insurance arms of AIG but not its Financial Products division, said, in a subsequent interview, that making it compulsory for CDS to be cleared via a central clearing counterparty was one way to ensure there was sufficient capital behind the transactions. "This should be mandatory, unless a specific exception for a type of financial instrument is obtained," he said.

Concerns that defaults of a big counterparty in the derivatives market - such as AIG - would have a negative knock-on effect on other dealers linked through the privately traded CDS market has led regulators to push for clearing to eliminate such systemic risks.

The credit derivatives industry continues thus-far voluntary moves to transfer swathes of the CDS market to clearing houses.

Dealers will meet with the Federal Reserve in New York on Wednesday to discuss efforts to reduce CDS risks.

Industry participants have said mandatory clearing could be too expensive, potentially closing down the market for tailor-made risk-management contracts.

Mr Dinallo's comments echo those of Mary Shapiro, the new chairman of the Securities and Exchange Commission.

Last week, Ms Shapiro said in a Senate hearing that centralised clearing should not be voluntary.

"We do not have the authority right now to require that. We would strongly recommend that Congress require central clearing of CDS.

"I am not a big believer in voluntary regulation. And I think that this is an area where we need authority," Ms Shapiro said.

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