Banks Prefer Mandatory CDS Clearing Over Exchange-Based Model

LONDON, Nov 20 - Some of the world's top banks are backing a proposal to develop a mandatory central clearing system for the $55 trillion credit default swap (CDS) market, a report in the Financial Times said on Thursday. Dealer banks are stepping up efforts to back CDS clearing to head off a more radical overhaul, which includes a proposal to move trading of over-the-counter CDS on to an exchange, the report said, citing an internal Morgan Stanley email.

Credit default swaps, which protect against a debt issuer's default, have been blamed for the worsening financial crisis, and banks fear that they might lose business if regulators insist on an exchange model for trading, the FT said.

"We have teamed up with a small group of dealers to put together a legal and regulatory proposal for CDS which we will propose to Congress and the Fed in an effort to address many of their concerns around CDS," said the internal email, sent by James Hill, a managing director at Morgan Stanley, according to the FT.

"This proposal will include mandatory clearing of CDS, margin rules, oversight of dealers and large market participants and SEC jurisdiction over anti-fraud and market manipulation activities," the email said.

Morgan Stanley could not immediately be reached for comment.

Publish Date:November 20, 2008
Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=212101000

PWG Offers Initiatives to Strengthen OTC Derivatives Oversight and Infrastructure

The President's Working Group on Financial Markets is rolling out a series of initiatives to strengthen oversight and the infrastructure of the over-the-counter derivatives market.

Initiatives include the development of credit default swap central counterparties, some of which will commence operations before the end of 2008, and the establishment of a Memorandum of Understanding regarding CDS central counterparties among the Federal Reserve Board of Governors, the Securities and Exchange Commission and the Commodity Futures Trading Commission. The PWG also rolled out a broad set of policy objectives to guide efforts to address the full range of challenges associated with OTC derivatives and issued a progress summary to provide an overview of the results of ongoing efforts to strengthen the infrastructure of OTC derivatives markets.

The Treasury Secretary serves as Chair of the group, which includes the Chairs of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The PWG, working with the Office of the Comptroller of the Currency and the Federal Reserve Bank of New York, has been actively overseeing improvements underway in OTC derivatives markets and the reports issued today identify the progress already made and specific objectives for the relevant supervisors going forward.

Over-the-counter derivatives are integral to the smooth functioning of today's complex financial markets and, with appropriate regulatory oversight and prudent management can enhance the ability of market participants to manage risk. The rapid growth of OTC derivatives markets over the past several years reflects their increasing importance to market participants.

Publish Date:Nov 17, 2008
Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=212100253

Cheque mate - How AIG got Uncle Sam over a barrel

JUST how concerned should American taxpayers be about American International Group (AIG), the insurance company brought to its knees by its escapades in the credit-derivatives market? On November 10th a revised rescue package was announced, comprising $153 billion of capital injections and loans. That is the largest bail-out for any firm, anywhere, during the crisis. Is the government being, as AIG’s new chairman says, “very, very smart”, or has it been taken for one of the most expensive rides in corporate history?

Even on September 16th, when the state first intervened, AIG was a controversial candidate for assistance. Its insurance businesses are ring-fenced by local regulators and individually capitalised, precisely so they can survive a collapse of the holding company. A bankruptcy was avoided only because of the size of the holding company’s book of toxic credit derivatives, which senior executives barely understood. These left AIG so intertwined with other financial firms that its failure was judged by the Federal Reserve and Treasury to endanger the financial system.

Whether that judgment was right remains unknowable. But it is now clear that the original plan was flawed. That may be understandable: panic was in the air, AIG faced crippling collateral calls and Lehman Brothers had just folded. And the authorities lacked the wide powers granted by the Troubled Asset Relief Programme (TARP) approved by Congress in October. Unorthodox options, such as splitting the systemically threatening credit derivatives from AIG, were not under discussion.

As a result, the original plan looked a lot like the traditional remedy for a liquidity crisis at a solvent bank. The Fed offered a two-year, $85 billion loan. AIG would pay a penal interest rate and cede to the state an equity stake of just under 80%. But as collateral calls mounted on the credit derivatives, and AIG admitted to new problems, it became plain that the loan was too small. It was also too expensive: in the first year it would have cost almost as much as AIG’s profits in 2006, its best year ever.

Meanwhile the chances of AIG being able to repay the loan also shrank. In the second quarter, it had only $59 billion of core equity capital (defined here as book equity less goodwill, tax assets and stock ceded to the state). By the third quarter, more losses had cut this to a meagre $23 billion. Worse, much if not all of AIG’s capital sits “stranded” in the ring-fenced insurance units. That makes it hard to funnel it up to a holding company that is otherwise almost certainly insolvent.

The original solution was to sell the insurance operations to raise cash, but with AIG’s competitors also reeling, this looked less and less realistic. The alternative, of AIG tapping credit markets to repay the state, became ridiculous by early November. AIG’s own credit spreads implied that the company was headed for default (see chart). Prospects of even rolling over the $64 billion of non-government borrowing due to mature by 2011 became increasingly bleak.

That forced the hand of the authorities. In one sense the new package does what, with the benefit of hindsight, should have happened all along. The Fed will provide $53 billion of funding for two vehicles which will, in effect, assume AIG’s most toxic credit derivatives and mortgage-backed securities. These positions have been marked to fairly conservative levels.

In an alternative universe the government could then walk away, confident that it had dealt with the worst of the systemically important credit derivatives and that the insurance operations remained safely ring-fenced. But in the real world the state is now the biggest lender to AIG, which has drawn down the bulk of the original $85 billion facility. AIG has Uncle Sam in a bind. As a result, the Treasury, through the TARP, has been forced to recapitalise the insurer by purchasing $40 billion of preference shares. Despite this its economic stake in the firm will remain just below 80%. The Fed will also maintain a loan facility, on more generous terms, of $60 billion. And if AIG struggles to refinance its debts, it is quite possible that the state will provide a formal guarantee.

The Treasury has secured crowd-pleasing concessions; for example limits on executives’ bonus payments. But the real question is whether the preference shares are safe. AIG has a trillion-dollar balance-sheet. There is now a thin buffer of core equity between the taxpayer’s preference shares and any further losses. The hope is still that as markets recover, AIG can sell the crown jewels of its insurance business at a premium to book value. That may well take years. Plenty of time to reflect on how an offer of a temporary loan, to a company that barely made the list of systemically vital firms, spiralled into one of the biggest corporate bail-outs ever.

Source URL: http://www.economist.com/finance/displaystory.cfm?story_id=12607251&fsrc=rss

Europe to Crack Down on Derivatives Risk

The European Commission said on Friday it intends to make proposals to control risks in the $60 trillion credit derivatives market, seen as one of the causes of the worst financial crisis in 80 years.

"Regulators need to have a much better view of where the real risks in these instruments lie," EU Internal Market Commissioner Charlie McCreevy said in a statement.

"I would like to have by the end of this year concrete proposals as to how the risks from credit derivatives can be mitigated," McCreevy said.

The contracts are traded over-the-counter or off an exchange, and are therefore more lightly regulated with risks less controlled.

Contracts could be standardised more, McCreevy said.

"But there is a far more pressing need and that is to have a central clearing counterparty for these derivatives," he said.

Standardised derivatives are already traded and cleared on exchanges such as Eurex, Liffe and the CME. But the off-exchange market, with its bespoke contracts, is far bigger.
One sector, credit default swaps (CDS) are "insurance" against a company defaulting and have been widely traded, with poor records of where these contracts have ended up or whether the owners have the capital to honour them if needed.

Central clearing for credit derivatives such as CDS contracts was particularly urgent, McCreevy said.

"No one is able to say how these swaps will unwind. Regulators have little sight of potential liabilities that could be building up for individual participants," he added.

McCreevy's moves mirror those in the United States where the Securities and Exchange Commission and Federal Reserve Chairman Ben Bernanke have said there should be more oversight of credit derivatives.

The Commodity and Futures Trading Commission, which oversees derivatives in the United States, has said centralised clearing of contracts is an "immediate" step that could be taken to cut risk.

Liffe said on Thursday it has struck a deal with Markit Group, a financial information provider, to launch exchange-traded credit default swaps that are cleared centrally.

Publish Date: October 17, 2008
Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=211201590

Wall Street Systems launches post-trade processing utility

Wall Street Systems has launched a "pay as you go" post-trade processing utility for FX cash, FX derivatives, money markets, vanilla interest rate derivatives, and listed futures and options.

Launched in conjunction with industry partners Currenex, Bloomberg, Icap and Logicscope, the Electronic Settlement Network (ESN) provides an outsourced, on-demand processing hub for financial institutions, eliminating the need for large investments in IT infrastructure, upfront software license fees and ongoing operating costs.

Its services span the entire post trade lifecycle including position management, P&L, deal confirmation, settlement, credit exposure, cash management, scenario and risk analysis, accounting, reconciliation, overall workflow and reporting.

Wall Street Systems' last foray into providing outsourced post-trade processing services was the Settlement & Operations Clearing eXchange (SOCX) - a joint venture with Deutsche Bank, that launched in 2001 but failed to win any clients. The venture closed when Deutsche Bank took its processing back in-house in 2003.

Tony White, managing director of product and research and development at Wall Street Systems, says the vendor learned a few important lessons from that experience.

"The costs and risks of many outsourcing arrangements are seen as being too high, so we've gone with a pay-as-you-go model for ESN, where we assume all the risk," says White.

"Having a bank involved as an owner of the utility is also not the best thing, as other banks don't want to benefit their competitor by helping reduce their cost of processing," he says. "And SOCX was also too technical, which turned off a lot of the tier two banks that could have been clients. So we've tried to make connectivity and client on-boarding as easy as possible by partnering with Logicscope."

Wall Street Systems also partnered with Logicscope last year to add post-trade notification and STP capabilities to its Wallstreet FX ASP hosted foreign exchange dealing system.

Wall Street Systems claims the on-demand ESN service sets the benchmark for the lowest trade processing costs in the industry. "It's coincidentally good timing to be launching such a service," says White. "With the current restructuring in the financial services industry there is an increased cost focus and a shift back to vanilla products. Tier two banks are also aware that there's no competitive advantage in trade processing."

Rajeena Brar, consultant at Pierre Audoin Consultants (PAC) says: "As FX further establishes itself as a fast-growing asset class, a utility model such as this is a natural evolution for the industry. This has been evidenced by the adoption of shared service models in other sectors, which have drastically improved operational efficiencies and costs."

On the issue of cost, White believes that lots of banks are deluding themselves about the true cost of processing, particularly small banks that don't have the volume required to run a cost-efficient processing operation.

While individual bank circumstances will vary, Wall Street Systems claims that ESN can reduce average cost per trade from $25 to under $1.

The company currently has three pilot customers that have been trialling the service - describes as "tier two banks", although one of them is among the top 10 banks in the US. In terms of geographic focus, the service is initially targeted at North American and European firms. The vendor hopes to have five clients on board by the end of this year and 10 by the end of 2009.

Source URL: http://www.finextra.com/fullstory.asp?id=19133

Bank of New York Mellon Chosen to Help Manage $700 Billion Bailout

The Bank of New York Mellon today confirmed that it has been selected by the U.S. Department of the Treasury to provide a range of services to support the government's Troubled Asset Relief Program authorized under the Emergency Economic Stabilization Act (aka the $700 billion bailout bill).

Treasury has hired the company to provide the accounting of record for the portfolio, hold all cash and assets in the portfolio, provide for pricing and asset valuation services and assist with other related services. The Bank of New York Mellon will serve as auction manager and conduct reverse auctions for the troubled assets.

The company's support will be administered through its securities servicing businesses.

"Our market leadership and experience have given us a keen understanding of the challenges facing the U.S. Treasury in these extraordinary times," said Robert P. Kelly, chairman and chief executive officer of The Bank of New York Mellon. "We will immediately deploy our resources and expertise, joining the team of public and private organizations that are working hard to earn the trust of the American taxpayers and to address the ongoing economic challenges."

The Bank of New York Mellon has a long history of partnering with the U.S. government to drive the development of the markets. Its founder, Alexander Hamilton, was the first Secretary of the Treasury. The company made the first-ever loan to the U.S. government and provided financing for the construction of the Erie Canal. Another key company leader, Andrew Mellon, served as Secretary of the Treasury during three presidential administrations.

Today, The Bank of New York Mellon has $23 trillion in assets under custody and administration, more than $1.1 trillion in assets under management and services $12 trillion in outstanding debt

Publish Date: Oct 14, 2008
Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=211200501

NY Fed Calls Friday Meeting for CDS Players to Determine Clearing House

The Federal Reserve Bank of New York said Wednesday it has summoned participants in the $55 trillion credit derivatives market to a meeting on Friday, which sources say will focus on determining which clearing house the market will support.

Calls for regulation and centralized clearing of credit default swap trades have gathered steam in the wake of Lehman Brothers' failure last month.

Critics charge that credit default swaps are central to the spreading fears in the markets and pose systemic risks, as the market's private nature makes it impossible to know the size of a counterparty's exposures and where they are distributed.

A central clearinghouse will remove the risk of a large counterparty failure.

There are several competing plans to launch a clearinghouse under way. But the Fed wants one clearing house to win widespread support, sources familiar with the meeting said.

The Fed hosted a meeting Tuesday to discuss the matter, but found no clear winner, sources said. The meeting on Friday will continue the discussions.

The Chicago Mercantile Exchange, or CME Group Inc , and Citadel Investment Group unveiled plans on Tuesday for an electronic exchange for credit default swaps, which they said would be integrated with a central clearinghouse.

The initiative is competing against dealer-owned Clearing Corp, which will act as a central counterparty to the market and is expected to launch by year-end.

Dealers have been hesitant to support exchange trading in the past as the private market is more profitable, and the liquidity they provide may be key to the success of exchange trading.
CME and Citadel are offering equity stakes in their joint venture to major market participants to encourage their support for the exchange.

Meanwhile, NYSE Euronext's Liffe unit has also said it will launch its BClear OTC clearing house facility in the fourth quarter.

U.S. business television channel CNBC also reported on Monday the Fed was planning talks with the CME and the Intercontinental Exchange, or ICE, on the creation of a credit default swaps exchange.

Publish Date:October 09, 2008
Source URL:http://www.financetech.com/showArticle.jhtml?articleID=210800639