Financial Regulatory Forum

US’s Frank wants SEC/CFTC to decide on swaps clearing

By Reuters Staff
November 4, 2009

By Kim Dixon and Karen Brettell
WASHINGTON/NEW YORK, Nov 3 (Reuters) – U.S. regulators should be given authority to determine whether a privately traded derivative contract should be cleared through a central clearinghouse, the chairman of the House Financial Services Committee said on Tuesday.

The move would be highly controversial as clearinghouses, which stand between parties to the trade and assume the risk of the failure of one of the parties, have maintained they should have the right to determine what contracts they clear and they have expressed reluctance about clearing risky contracts.

The congressional panel has approved a bill to regulate the $450 trillion over-the-counter derivatives market, after credit default swaps (CDS) were blamed for exacerbating the global financial crisis.

But Financial Services Committee Chairman Barney Frank said he wanted to change the bill to take authority to determine whether swaps are clearable away from private clearinghouses.

“I am having staff prepare an amendment to give that function back” to the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), Frank told reporters.

Under Frank’s bill, private clearinghouses, some of which are owned by financial institutions, have the power to determine whether a swap can be cleared.

But in a potential loophole, financial firms, which oppose the mandate that certain derivatives be traded, might have an incentive to not declare trades clearable, Frank told reporters.

The change will likely face opposition from market participants who have said that clearinghouses should have the option to decline risky or hard to value assets if they are put at risk of failing themselves.

“If central counterparties are forced to clear something they don’t feel comfortable with, we’d end up creating new systemic risk rather than reducing it,” said Kevin McPartland, senior analyst at TABB Group in New York.

Frank also said trading between financial institutions will need to be made on exchanges, without exemption. This rule would cover all banks that have traded with American International Group <AIG.N>, which he deemed “the poster child” of derivative problems.

AIG needed a government bailout out after selling hundreds of billions of dollars of protection on risky assets using CDSs.

Frank said he and House Agriculture Committee chairman Collin Peterson are very close to a deal to merge both panel’s bills.

SYSTEMIC RISKS
Clearinghouses concentrate the exposures of large trading counterparties, and pose large risks to the financial system if they are undercapitalized.

Derivative contracts can be used to hedge against or bet on the changes in value of the underlying assets such as stocks, bonds, commodities.

Enforcing margin requirements on many derivatives, such as credit default swaps, can be challenging as the value of the contracts can rapidly change if a borrower is suddenly deemed near default. In some cases defaults can occur before sufficient collateral payments can be made.

“There’s a fairly significant risk that if a regulator decides they have to clear something and can set capital or otherwise determine how to appropriately clear a product, we have succeeded in just pushing risk to clearing corporations and raised the risk that they may not have adequate capital,” said Paul Forrester, partner at law firm Mayer Brown in Chicago.

“That’s a potentially larger problem than the one we’re trying to solve,” he said.

Executives at CME Group Inc and LCH.Clearnet, both of which plan to clear credit default swaps, have said they are wary of clearing contracts that trade infrequently or have few pricing sources. For details, see

Frank said he also requested the change in a letter to CFTC Chairman Gary Gensler. The full House still needs to vote on the bill, and the Senate must agree before president Barack Obama could sign it into law.

(Additional reporting by Rachelle Younglai)
((kim.dixon@reuters.com; +1 202 354-5864; Reuters Messaging: kim.dixon.reuters.com@reuters.net))

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