As we have previously reported, the Federal Reserve has been in discussions with industry participants for several weeks in order to create a clearinghouse for the trading and settlement of credit default swaps and other over-the-counter derivatives. The purposes of a central counterparty system are to enhance standardization and liquidity in the market and also to provide for a systematic way to address counterparty credit risk.

In furtherance of that effort, today the President’s Working Group on Financial Markets (the “PWG”) announced that the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission and the Commodity Futures Trading Commission have signed a memorandum of understanding (the “MOU”) that regulators believe will lead to the establishment of one or more clearinghouses for credit default swaps before the end of the year. In its statement, the PWG stated that potential central counterparty providers have accelerated their efforts to establish clearing arrangements and that the federal regulators who are parties to the MOU are assessing those proposals by conducting detailed on-site reviews of risk management and other key design elements. The purpose of the MOU is to share information, coordinate responsibility for regulatory oversight and to streamline the process for approval of the clearinghouse.

In addition, the PWG announced new policy objectives to guide efforts to address challenges surrounding other OTC derivatives that do not have the trading volumes necessary to support an active trading market. The PWG’s policy objectives are:

  • Improve the transparency and integrity for credit default swaps by, among other things, public reporting of prices, trading volumes and aggregate open interest market.
  • Enhance risk management of OTC derivatives through, among other things, consistent regulatory oversight and risk management policies.
  • Further strengthen the OTC derivatives market infrastructure through the establishment of central counterparty arrangements, establishment of electronic trading facilities and improved operational infrastructure.
  • Strengthen cooperation among regulatory authorities through assuring adequate enforcement authority and increased cooperation with foreign regulators.

According to published reports, the Federal Reserve Bank of New York has been pressing CME Group Inc. (the holding company for the Chicago Mercantile Exchange, the New York Mercantile Exchange and the Chicago Board of Trade), IntercontinentalExchange, Inc. and NYSE Euronext (the parent of the New York Stock Exchange) to accelerate the establishment of a clearinghouse. Both CME Group and Intercontinental have indicated that they will be ready to begin clearing contracts by year-end or sooner, depending upon receipt of regulatory approval.

Regulators and industry executives are hopeful that the clearing arrangements will help minimize future shocks to the financial system like those that crippled financial markets after the failure of Lehman Brothers Holdings Inc. and the near failure of American International Group, Inc. Successful establishment of a clearinghouse for credit default swaps could have a significant impact on valuations of the swaps and, accordingly, on the balance sheets of the banks and other institutions holding currently unmarketable derivatives. In addition, it could also quell the raging debate over mark-to-market accounting rules.

A copy of the MOU has been posted at http://www.treas.gov/press/releases/reports/finalmou.pdf and other government websites.