The Clearinghouse Cure

Credit Default Swaps (CDSs) are casting an enormous shadow over the world’s crisisplagued financial markets — as in $50 trillion-plus enormous (although the exact meaning of this oft-quoted figure is somewhat contentious). CDSs were not the source of the ongoing financial crisis (that dubious honor largely goes to complex collateralized debt obligations backed by home mortgages, especially subprime mortgages), but financial markets are filled with fear that a default by a large CDS trader would rip through the financial system, causing a cascade of defaults by other firms. The Federal Reserve and the Treasury Department have responded by bailing out big, financially troubled swaps dealers, including Bear Stearns and AIG, that had large CDS positions, and regret their decision not to bail out another large dealer, Lehman Brothers.

The dread prospect that massive defaults on CDSs could crater the world financial system has led to numerous calls for CDS market reform and regulation. Regulators on both sides of the Atlantic and many market participants have seized on the idea of a clearinghouse for these contracts as the way to make the market more secure and protect the broader banking and capital markets from the prospect of CDS contagion. The Federal Reserve Bank of New York has held numerous meetings with major market participants and has put substantial pressure on them to create a CDS clearinghouse. Five
exchanges have presented proposals to this effect. In Europe,European commissioner for the Internal Market Charlie McCreevy has publicly called for the formation of a clearinghouse to mitigate risks in the CDS market.