Street Seeks Credit-Default Safety Net

More than a dozen firms including investment banks, brokerage firms and futures exchanges are accelerating efforts to create a clearing entity that would function as the middleman between firms on both sides of a credit-default swap. The clearinghouse would guarantee payment on the contracts it handles, reducing the risk of a catastrophic ripple effect if one or more firms were unable to make good on their trades. Behind the push is growing worry about the runaway popularity of credit derivatives. The volume of credit-default swaps, which are private financial contracts that act as a form of insurance against bond and loan defaults, has surged to new highs. But last month's near collapse of Bear Stearns Cos. underscored the vulnerability of other firms that had trades with the Wall Street firm. Plans call for the credit-default-swaps clearinghouse to be operated by Clearing Corp., a Chicago futures-clearing firm that is backed by Goldman Sachs Group Inc., Citigroup Inc., J.P. Morgan Chase & Co., Deutsche Bank AG, German-Swiss futures exchange Eurex AG and other financial-services firms. The project is likely to be launched in the second half of 2008. Supporters say the operation would back the obligations of credit-default swaps, standing between dealers in such trades, just as clearinghouses now do for a wide variety of other investments. The behind-the-scenes clearing business is a lucrative and fast-growing area of Wall Street, especially for exchange operators. Regulators also believe that a "central counterparty" could reduce the risk of a financial epidemic triggered by problems at one financial institution. Barclays Capital earlier this year estimated the failure of a major credit-derivatives player could lead to losses of $36 billion to $47 billion across the financial system. But the inherent lack of transparency in the largely unregulated credit-derivatives market could make the task difficult. Unlike the stock, futures and options markets, where market prices of securities and contracts are widely available, credit-default swaps trade "over the counter" -- or away from exchanges -- and prices can vary from firm to firm. Hoping to overcome the pricing problems, Clearing Corp. is working with Markit Group, which collects credit-default-swap prices from multiple firms. It also plans to initially clear trades for indexes of credit-default swaps, which have terms that are more standardized than swaps on individual bonds. "We are intent on maintaining a vibrant over-the-counter market for credit-default swaps," says Athanassios Diplas, chief risk officer for global credit trading at Deutsche Bank. Under the Clearing Corp. plan, participating dealers would each put money in a fund to help cover trading losses if any one firm fails. To protect itself, the clearinghouse will require margin from each firm and could request more collateral based on market moves. Industry participants have been working on the plan for about a year and hope to hammer out details in time to clear trades this year. For most of its history, Clearing Corp. cleared Treasury and other futures contracts for the Chicago Board of Trade. It lost that business in 2003 when CBOT moved its clearing to the Chicago Mercantile Exchange. Clearing Corp. has since expanded from exchange-listed futures to the over-the-counter market. Last year, it restructured its shareholder base, adding some holders that specialize in over-the-counter trading. Meanwhile, CME Group Inc., which now owns the Chicago Merc and the Chicago Board of Trade, also wants to expand into the bigger over-the-counter market. In March, it bought Credit Market Analysis Ltd., a credit-derivatives-data provider. "We view that as an entree" into credit-derivatives trading or clearing, says Craig Donohue, the exchange company's CEO.