Story URL: http://news.medill.northwestern.edu/chicago/news.aspx?id=100773
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CME urges exchange-based market for credit default swaps

by Ryan Graff
Oct 14, 2008


The executive chairman of Chicago’s CME Group Inc. argued on Capitol Hill Tuesday for the creation of a regulated, exchange-based market for credit default swaps, one of the "toxic" financial intruments blamed for the current financial crisis.  Senators responded with interest.

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

“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.”  Credit default swaps are akin to insurance, purchased by securities holders to protect against any loss in their value.

An exchange market, Duffy argued, increases transparency.

“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.

And switching to a regulated exchange-based system would increase risk assessment, he argued.

“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 and AIG crisis.”  Bear, Stearns & Co. Inc. was forced into a protective merger and American International Group Inc. was bailed out by the government.

Duffy didn’t call for a ban on over-the-counter trades between individuals, 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 council of IntercontinentalExchange Inc., which operates exchanges that compete with CME.

Senator Mike Crapo, R-Idaho, questioned whether a single exchange, CME or a competitor, ought to be the sole provider of regulated credit default swaps.

“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.”

However, he added, certain exchanges already offer exclusive products, so there would be 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 percent to 90 percent of the trades in credit default swaps could be standardized.

Senators commented that 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.