Clearinghouse for Credit Default Swaps Moves Ahead

Trading murky derivatives known as Credit Default Swaps got a little closer to transparency when the Securities & Exchange Commission took steps to allow a major stock exchange and a British-owned firm to act as a clearinghouse.

The SEC has granted an exemption to let NYSE Euronext, owner of the New York Stock Exchange, and its partner LCH.Clearnet Group Ltd., to clear CDSs. Meanwhile, two other firms IntercontinentalExchange Inc. of Atlanta, and CME Group of Chicago, are awaiting a similar temporary SEC exemption so they can set up shop as CDS clearinghouses.

Setting up such clearinghouses is considered essential to bring order and transparency to trading CDS, which are unregulated derivatives that offer buyers a payout if the firm against which they are written defaults or goes bankrupt. Initially, CDSs were hailed as a an innovative bit of financial engineering and soon they came to represent about $62.2 trillion in assets.

CDSs, however, ended up being blamed for part of the turmoil that put Lehman Brothers out of business and helped tip American International Group into the need for massive federal bailouts and loans. AIG had covered about $440 billion in bonds that involved Credit Default Swaps.

Building clearinghouses with more regulations and order is considered a key step in making sure that CDSs operate in safe and less risky ways. For example, when a CDS trade is registered in a central clearinghouse, it is legally bound to ensure that the deal works out and may be required to prop up the deal with its own capital if needed.

The SEC now needs to consider making its temporary exemption for the NYSE-Euronext-LCH.Clearnet deal permanent. It also has to consider similar temporary exemptions for the Chicago and Atlanta firms.

IntercontinentalExchange Inc. won approval Dec. 4 for a New York trust charter from the New York State Banking Department. The Georgia firm is competing with CME Group of Chicago which plans its own CDS clearinghouse.

At the moment, clearing CDSs are handled by the The Depository Trust and Clearing Corp. which typically holds auctions to dispose of troubled assets. Depository Trust has something like $72 billion of CDS contracts on Lehman alone.