On November 14, 2008, the President’s Working Group on Financial Markets (the “Working Group”) announced initiatives to strengthen the oversight and the infrastructure of the over-the-counter (“OTC”) derivatives market. The Working Group, which is comprised of representatives of the Department of the Treasury, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the Commodity Futures Trading Commission (the “CFTC”) and the Securities and Exchange Commission (the “SEC”), announced (i) the development of credit default swap (“CDS”) central counterparties; (ii) the adoption of a Memorandum of Understanding (“MOU”) among the Federal Reserve, the SEC and the CFTC to cooperatively implement the regulatory and operational framework to supervise central counterparties for CDS transactions; and (iii) general policy objectives concerning the use and operations of OTC derivatives markets.  

The Federal Reserve, the CFTC and the SEC entered into the MOU to cooperatively implement a central counterparty plan for CDS transactions. The MOU incorporates the intentions of each of the parties to cooperate, coordinate and share information while carrying out their respective responsibilities and authorities. Although arrangements for the creation and regulation of the CDS central counterparties have not been finalized, the MOU is the first formal pronouncement regarding comprehensive federal oversight of the CDS market. The following is a summary of the Working Group’s initiatives, together with a list of issues for market participants to bear in mind.  

CDS Central Counterparties  

The Working Group’s top short-term priority concerning the OTC derivatives market relates to overseeing the implementation of central counterparties for CDS transactions. By establishing CDS central counterparties, the Working Group hopes to reduce systemic risk associated with counterparty credit exposures, facilitate increased market transparency and create a more competitive trading environment.

Several potential CDS central counterparties have been identified by the Working Group. At the request of the Working Group, these providers have accelerated their development efforts. The MOU specifically recognizes that a CDS central counterparty may be organized as one of the following: a state-chartered bank that is a member of the Federal Reserve and subject to its supervision; a derivatives clearing organization (as defined in Section 1a(9) of the Commodity Exchange Act) subject to supervision by the CFTC; or a clearing agency (as defined by the Exchange Act) subject to supervision by the SEC. The regulatory authorities are assessing and reviewing the providers in an attempt to expedite regulatory approvals and/or exemptions. The Working Group anticipates that one or more of the CDS central counterparties will commence operations by year-end.

Policy Objectives & Questions

The Working Group also announced four policy objectives in respect of the OTC derivatives market, with a particular emphasis on CDS transactions. These policy objectives consist of (i) improving market transparency and integrity for CDS transactions; (ii) enhancing risk management by users of OTC derivatives; (iii) strengthening OTC derivatives market infrastructure; and (iv) continuing cooperation among regulatory authorities.  

The Working Group’s announcement clearly articulates the federal government’s commitment to effectively regulate the CDS market. However, market participants – both derivatives dealers and endusers – should bear the following questions in mind as the overarching framework for CDS central counterparties emerges.  

  •  Will a guarantee of settlement be created that is sufficiently strong to prevent a systemic risk to the financial system upon the failure of a dominant CDS seller?  
  •  What are the mechanisms for dispute resolutions and resolving events of default?
  • Will CDS central counterparties provide real-time pricing, and what methods will be established to create a more reliable mark-to-market process?  
  •  Will regulatory oversight be mandatory, or may certain participants opt out?  
  •  What role will ISDA play with respect to the CDS central counterparties?  
  •  Will the introduction of the CDS central counterparties increase the regulators’ tolerance for CDS transactions?  
  •  Will the creation of the CDS central counterparties increase or decrease the acceptance of other OTC derivatives not clearing through the clearinghouse?

A copy of the Working Group’s announcement, together with a link to the MOU and a detailed discussion of the policy initiatives, can be found at http://www.ustreas.gov/press/releases/hp1272.htm.