CME wants to tackle credit default swaps

Ryan Graff, Medill News Service

The executive chairman of Chicago’s CME Group Inc. argued for the creation of a regulated exchange-based system for the credit default swap market on Capitol Hill on Tuesday.

CME’s Terrence Duffy told members of the Senate Committee on Agriculture, Nutrition and Forestry that an exchange system, like one of derivatives exchanges CME runs, would reduce the risk from the current market by 10 fold.

Credit default swaps are one of the “toxic” financial instruments blamed in the current financial crisis.

“The financial crisis is not a consequence of the instruments,” Duffy said, reading from a prepared statement. “It is a problem with distribution and trading of such contracts in the unregulated, over-the-counter market that has not employed sufficient disclosure and risk management techniques.”

An exchange market, Duffy argued, would increases transparency in the market and would also help to asses risk.

“It has been the lack of price transparency and the failure to properly measure and collateralize the risk of those instruments in the OTC markets that has had dire consequences,” he said.

Switching to a regulated exchange-based system would increase risk assessment.

Under the current system, “the true consequences of a default by one or more participants cannot be measured,” Duffy said. Which was “exactly the sort of systemic risk brought to light by the (Bear, Stearns & Co. Inc.) and (American International Group Inc.) crisis.”

Duffy didn’t advocate for a ban on trades between individuals, known as over-the-counter trades, but said that that type of trading ought to be limited to “truly sophisticated investors trading contracts that are too individualized or too thinly traded to be brought onto a trading platform.”

Duffy appeared on a panel with Jonathon Short, general counsel of Intercontinental Exchange Inc., which operates exchanges that compete with CME. Senator Mike Crapo, R-Idaho, questioned whether a single exchange, CME or one of its competitors, ought to be the sole provider of regulated credit default swaps and the dangers of concentrating the market in one exchange.

“I always believe there’s room for competition, so I don’t have any problem with that,” Duffy said. “We will compete for this business.”

Certain exchanges already offer exclusive products, Duffy added, so there is little risk if the credit default swap market were concentrated in one exchange as well.

Short argued that the problem with an exchange-based system is that it can’t handle customized products or products that are traded only occasionally because exchanges require standardization.

But Duffy said that CME had figured that 80 to 90 percent of the trades in credit default swaps could be standardized.

An exchange for credit default swaps has hurdles to clear. Namely a law has to be created allowing it, and lawmakers have to decide which government body would be charged with regulating it.