Fed, Banks Agree on Credit-Swap Changes to Cut Risk of Collapse

By Shannon D. Harrington and Oliver Biggadike


June 10 (Bloomberg) -- Regulators and banks agreed to changes aimed at easing the risk of a collapse in the $62 trillion market for credit-default swaps.

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. are among the 17 banks creating a system to move trades through a clearinghouse that would absorb a failure by one of the market-makers, the Federal Reserve Bank of New York said yesterday in a statement following a meeting with the firms. A guarantee may encourage more trading of default swaps, said NanaOtsuki of UBS AG, one of the banks involved in the agreement.

``Increasing liquidity as a result of the settlement house would be the key,'' said Otsuki, head of debt and equity research for Japanese financial institutions at UBS in Tokyo. ``Larger trading volume means higher efficiency.''

The central counterparty, more automated trading and settlement and other fixes ``will help improve the system's ability to manage the consequence of failure by a major institution, and we expect to make meaningful progress over the next six months,'' New York Fed President Timothy Geithner said in a speech to the Economic Club of New York yesterday.

Systemic Losses

Concerns that the market could fail erupted in March when Bear Stearns Cos., then the fifth-biggest U.S. securities firm, faced a cash squeeze. The central bank agreed to back an emergency sale of Bear to JPMorgan Chase & Co. in part because of the systemic losses that would have resulted if the firm had filed for bankruptcy, Geithner said.

The Fed has conferred with banks since September 2005 to improve processing and settlement in the market. Ten of the 17 banks at the meeting yesterday were owners of Chicago-based Clearing Corp., which has said it will start guaranteeing credit-default swap trades by September.

Investment firms AllianceBernstein LP, Citadel Investment Group LLC and BlueMountain Capital Management LLC joined the meetings yesterday for the first time.

In addition to a central clearing mechanism, the group agreed to include in standard trading documents a mechanism for settling trades with cash instead of having to physically deliver the underlying securities.

The group will reduce the volume of outstanding contracts through multilateral trade terminations. They also agreed to extend the changes in credit-default swaps to other derivatives contracts backed by equities, interest rates, currencies and commodities.

The group will provide details on its next steps by July 31, the Fed said in its statement.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value should the company fail to adhere to its debt agreements.