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Testimony: 

Before the Subcommittee on Capital Markets, Insurance, and Government 
Sponsored Enterprises: 

United States Government Accountability Office: 
GAO: 

For Release on Delivery: 
Expected at 10:00 a.m. EST:
Thursday, March 5, 2009: 

Systemic Risk: 

Regulatory Oversight and Recent Initiatives to Address Risk Posed by 
Credit Default Swaps: 

Statement of Orice M. Williams, Director:
Financial Markets and Community Investment: 

GAO-09-397T: 

GAO Highlights: 

Highlights of GAO-09-397T, a testimony to Congressional Requesters. 

Why GAO Did This Study: 

The U.S. financial system is more prone to systemic risk today because 
(1) the current U.S. financial regulatory system is not designed to 
adequately oversee today’s large and interconnected financial 
institutions, (2) not all financial activities and institutions fall 
under the direct purview of financial regulators, and (3) market 
innovations have led to the creation of new and sometimes complex 
products that were not envisioned as the current regulatory system 
developed. Credit default swaps (CDS) are one of the products that have 
assumed a key role in financial markets. 

My statement will discuss (1) the extent to which U.S. financial 
regulators and the UK regulator oversee CDS, (2) risks and challenges 
that CDS present to the stability of financial markets and institutions 
and similar concerns that other products may pose, and (3) the recent 
steps that financial regulators and the industry have taken to address 
risks pose by CDS and similar efforts that may be warranted for other 
financial products. GAO reviewed research studies and congressional 
testimonies. We interviewed financial regulators and a variety of 
financial market participants. 

In January 2009, GAO designated the financial regulatory system as a 
high-risk area in need of congressional attention. Issues involving 
systemic risk regulation in general and CDS in particular should be 
considered as part of that effort. 

What GAO Found: 

The current regulatory structure for CDS does not provide any one 
regulator with authority over all participants in the CDS market, 
making it difficult to monitor and manage potential systemic risk. 
Federal oversight of CDS trading and monitoring of the CDS market are 
largely conducted through the banking regulators’ safety and soundness 
oversight of supervised banks that act as CDS dealers. The Securities 
and Exchange Commission and the Commodity Futures Trading Commission 
lack the authority to regulate CDS broadly as financial products. 
Regulators have sought to address potential systemic risks arising from 
CDS activities mainly through collaborative efforts with other 
supervisors and key market participants. However, the extent to which 
regulators routinely monitor the CDS activity of unregulated market 
participants is unclear. The Financial Services Authority in the United 
Kingdom has authority over most CDS products and can collect 
information about the CDS market, but it has pursued most of its 
regulatory efforts in collaboration with U.S. regulators. 

CDS pose a number of risks to institutions and markets, many of which 
are not unique. These include counterparty credit, operational, 
concentration, and jump-to-default risks. Market participants and 
observers noted that CDS referencing asset-backed securities (ABS) and 
collateralized debt obligations (CDOs), particularly those related to 
mortgages, currently pose greater risks to institutions and markets 
than other types of CDS. Other risks and challenges from CDS relate to 
the lack of transparency in CDS markets, the potential for manipulation 
related to the use of CDS as a price discovery mechanism, and the use 
of CDS for speculative purposes. Regulators and market participants 
noted that over-the-counter (OTC) derivatives, to varying degrees, may 
pose some similar risks and a few identified equity derivatives as the 
OTC derivatives that were most similar to CDS. 

Financial regulators and market participants have initiated several 
efforts to mitigate these risks. These efforts target primarily 
operational and counterparty credit risks and include improving the 
operational infrastructure of CDS markets, creating a clearinghouse or 
central counterparty process to clear CDS trades, and establishing a 
central trade registry for CDS. If effectively implemented and 
sustained, these initiatives could begin to address some of the risks 
noted. But the effectiveness of these recent initiatives could be 
limited because participation is voluntary and regulators lack the 
authority to require all market participants to report their trades to 
a repository. Moreover, customized and highly structured CDS, which can 
include CDS with complex reference entities that may present additional 
risks, generally lack the standardization necessary for centralized 
clearing. Other ideas to reform CDS markets, such as mandatory clearing 
or limiting some types of trades, have important limitations that would 
need to be addressed. Finally, many participants and observers agreed 
that OTC derivatives other than CDS generally share some of the same 
risks and could benefit from similar efforts to mitigate their impact. 

View [hyperlink, http://www.gao.gov/products/GAO-09-397T] or key 
components. For more information, contact Orice M. Williams at (202) 
512-8678 or williamso@gao.gov. 

[End of section] 

Chairman Kanjorski and Members of the Subcommittee: 

I appreciate the opportunity to participate in the hearing today to 
broadly discuss systemic risk and in particular the systemic risk posed 
by credit default swaps (CDS) and other over-the-counter (OTC) 
derivatives. As you well know, there is no single definition for 
systemic risk. Traditionally, systemic risk was viewed as the risk that 
the failure of one large institution would cause other institutions to 
fail. This micro-level definition is one way to think about systemic 
risk. Recent events have illustrated a more macro-level definition: the 
risk that an event could broadly affect the financial system rather 
than just one or a few institutions. In our January 2009 report on the 
U.S. financial regulatory system, we pointed out that the current 
regulatory system was not designed to adequately oversee today's large 
and interconnected financial institutions, whose activities pose new 
risks to the institutions themselves and systemic risk to the broader 
financial system.[Footnote 1] We also noted that not all financial 
activities and institutions fall under the direct purview of financial 
regulators and that market innovations had led to the creation of new 
and sometimes complex products whose complexity and substantial role in 
the financial system was not envisioned as the current regulatory 
system developed. Credit default swaps are one of the products that 
have assumed a key role in financial markets. They are being used by 
financial institutions that are subject to varying degrees of 
regulation, and the market for CDS is largely unregulated in the United 
States. 

My statement today focuses on the results of prior work and our recent 
review of CDS and the risks that they and other OTC derivatives pose to 
the financial system (initiated at the request of Ranking Member Bachus 
and Chairman Kanjorski). Specifically, I will discuss (1) the extent to 
which U.S. financial regulators and the UK regulator oversee CDS, (2) 
risks and challenges that CDS present to the stability of financial 
markets and institutions and similar concerns that other products may 
pose, and (3) the recent steps that financial regulators and the 
industry have taken to address risks posed by CDS and whether similar 
efforts may be warranted for other financial products. 

To achieve our objectives, we analyzed publicly available reports, 
congressional testimonies, and other documents issued by international 
financial organizations, academics, financial regulators, industry 
groups, and market participants. We also corresponded with the New York 
State Insurance Department, the UK Financial Services Authority (FSA), 
and two clearinghouses. We interviewed staff from the Board of 
Governors of the Federal Reserve System (FRS), Commodity Futures 
Trading Commission (CFTC), Federal Reserve Bank of New York (FRBNY), 
Office of the Comptroller of the Currency (OCC), Office of Thrift 
Supervision (OTS), President's Working Group on Financial Markets 
(PWG), and the Securities and Exchange Commission (SEC). Finally, we 
spoke with representatives of three CDS dealer banks, a credit rating 
agency, an industry trade group, five hedge funds, a large provider of 
derivatives trade and settlement services, and a large provider of CDS 
pricing and valuation services, as well as speaking with two industry 
observers. We provided a summary of our findings to the FRS, OCC, OTS, 
and SEC, and this statement was based on those summaries and 
incorporates their comments as appropriate. 

We conducted our work from October 2008 to February 2009 in accordance 
with all sections of GAO's Quality Assurance Framework that are 
relevant to our objectives. The framework requires that we plan and 
perform the engagement to obtain sufficient and appropriate evidence to 
meet our stated objectives and to discuss any limitations in our work. 
We believe that the information and data obtained and the analysis 
conducted provide a reasonable basis for our findings and conclusions. 

Summary: 

The current regulatory structure for CDS and other OTC derivatives does 
not provide any one regulator with the authority over all market 
participants, making potential systemic risk hard to monitor and 
manage. In the United States, federal oversight of CDS trading is 
largely conducted through the banking regulators' safety and soundness 
oversight of the supervised banks that act as dealers in the market. 
Unlike equities or futures markets that are regulated by SEC and CFTC 
respectively, CDS are not regulated broadly as financial products 
because SEC and CFTC lack authority to do so. Federal financial 
regulators, namely the banking regulators, generally monitor activity 
in the CDS market through information obtained from their supervised 
entities, but comprehensive and consistent data on the overall market 
have not been readily available. Regulators have sought to address 
potential systemic threats arising from CDS activities mainly through 
collaborative efforts with other U.S. and foreign supervisors and key 
market participants. However, the extent to which regulators routinely 
monitored the CDS activity of unregulated market participants is 
unclear. While U.S. federal financial regulators do not have authority 
over CDS as a product, in the United Kingdom, FSA has authority over 
most CDS products and can collect information on those products. 
Despite this broader authority, FSA has pursued most of its regulatory 
efforts in collaboration with U.S. regulators. 

CDS pose a number of risks, including: 

* Counterparty credit risk--the risk to each party in an OTC 
derivatives contract that the other party will not perform the 
contractual obligations. 

* Operational risk--the potential for losses that could occur from 
human errors or failures of systems or controls. 

* Concentration risk--the potential for loss when a financial 
institution establishes a large net exposure in similar types of CDS. 

* Jump-to-default risk--the risk that the sudden onset of a credit 
event will cause an abrupt change in a firm's CDS exposure. 

Market participants pointed out that the degree of risk associated with 
CDS can vary depending on (1) the type of CDS, (2) the reference entity 
for the CDS, and (3) how the CDS is used. Market participants and 
observers noted that CDS referencing asset-backed securities (ABS) and 
collateralized debt obligations (CDOs), particularly those related to 
mortgages, currently pose greater risks to institutions and markets 
than other types of CDS. Other risks and challenges from CDS relate to 
the lack of transparency in CDS markets, the potential for manipulation 
related to the use of CDS as a price discovery mechanism, and the use 
of CDS for speculative purposes. It is also important to note that many 
of these risks are not unique to CDS. Regulators and market 
participants noted that OTC derivatives may share some similar types of 
risks as CDS, but the degree of risk can vary. Equity derivatives were 
identified as the OTC derivatives that were most similar to CDS in 
terms of the risks and challenges that they presented. 

Recognizing the threat that CDS and other OTC derivatives could pose to 
the financial system, regulators and market participants have initiated 
several efforts to address certain risks posed by CDS. These efforts 
have primarily targeted operational and counterparty credit risks and 
include improving the operational infrastructure of CDS markets, 
creating a clearinghouse or central counterparty process to clear CDS 
trades, and establishing a central trade registry for CDS. If 
effectively implemented and sustained, these initiatives have the 
potential to begin to address some of the risks related to the use of 
CDS and other OTC derivatives. However, the effectiveness of these 
recent initiatives could be limited because participation is voluntary 
and regulators lack the authority to require all market participants to 
report their trades to a repository. Moreover, the more customized and 
highly structured CDS, which can include CDS on complex reference 
entities (e.g., ABS and CDOs) that may present additional risks to 
institutions and financial markets, generally lack the standardization 
necessary for centralized clearing. As a result, individual 
institutions' management of CDS risks remains critical to these 
institutions' safety and soundness. Similarly, management of 
counterparty credit risk is critical to any future central 
clearinghouse, which would concentrate exposure to CDS and could pose 
systemic risk. Other ideas to reform CDS markets, such as mandatory 
clearing or limiting some types of CDS trades, have important 
limitations or challenges that would also have to be addressed. Many 
participants and observers agreed that OTC derivatives other than CDS 
generally share some of the same types of risks, although to varying 
degrees, and could benefit from similar efforts to mitigate their 
impact. 

Background: 

As originally designed, CDS are bilateral contracts that are sold over 
the counter and transfer credit risks from one party to another. The 
seller, who is offering credit protection, agrees, in return for a 
periodic fee, to compensate the buyer, who is purchasing it, if a 
specified credit event, such as default, occurs (see figure 1). There are 
three standard types of CDS contracts, depending on the underlying 
reference entity. 

* A single-name CDS is based on a single reference entity such as a 
bond, institution, or sovereign entity. 

* A multi-name CDS references more than one corporate or sovereign 
entity and can be divided into those that reference at least 2 but not 
more that 10 entities and those that reference more than 10 entities. 

* An index CDS is based on an index that may include 100 or more 
corporate entities. 

The contract term often ranges from 1 to 10 years, with most standard 
CDS contracts having a 5-year duration. 

Figure 1: Overview of a CDS Contract: 

[Refer to PDF for image: illustration] 

Protection buyer: Periodic premium payment; 

Protection seller: 
Does credit event occur? (failure to pay, bankruptcy,or restructuring) 
If yes: Settlement: Two types: 
- Physical (buyer gives bonds or loans to seller in exchange for 
notional amount of contract); 
- Cash (seller pays buyer notional amount of contract less market 
value; market value determined by auction process). 

Source: GAO. 

[End of figure] 

Participants in the CDS market include commercial banks, broker 
dealers, hedge funds, asset managers, pension funds, insurance and 
financial guaranty firms, and corporations. CDS can provide a number of 
benefits, such as giving some market participants another tool to 
manage credit risk. They also are a way to replicate an investment in a 
debt instrument such as a bond. However, in 2008, as the United States 
and the world faced one of the worst financial crises in history, some 
market observers identified CDS as one of several financial products 
they believed had contributed to the overall tightening in the credit 
markets following the bankruptcy of Lehman Brothers and the near- 
collapse of American International Group (AIG), which was a major CDS 
seller. Although authoritative information about the actual size of the 
market is generally not available, some have estimated the amount of 
outstanding contracts--as measured by the notional amount of the CDS 
contracts--at over $50 trillion in 2008. However, more recent figures 
place the notional amount at around $28 trillion, in part reflecting 
trade compression efforts. These market events and the estimated size 
of the CDS market have raised concerns about the risks that CDS and 
similar financial products may pose to the stability of the financial 
system. Furthermore, questions have been raised about the current level 
and structure of oversight of CDS and their impact on the financial 
system. In the last 3 years, CDS market participants and financial 
regulators have been taking actions to help mitigate various risks and 
challenges related to CDS activities, with a particular focus on the 
market's infrastructure. 

CDS Oversight Highlights the Challenges of an Outdated Regulatory 
System: 

In the United States, federal financial oversight of CDS is limited. 
Banks, whose activities as CDS dealers account for a large percentage 
of CDS trading, are subject to safety and soundness oversight by 
banking regulators. Bank regulators therefore have the authority to act 
on their concerns about the extent to which a banking organization's 
CDS trading affects the health of the bank. However, oversight of banks 
acting as dealers does not directly extend into the CDS product market 
itself. In addition, federal financial market regulators--primarily SEC 
and CFTC--are generally limited or restricted in their ability to 
oversee CDS broadly as a product because they lack statutory authority. 
SEC has antifraud and antimanipulation authority over CDS, but it may 
face challenges in enforcing this authority because of statutory 
restrictions on its rule-making ability. Federal financial regulators 
have sought to address potential systemic threats arising from CDS 
activities mainly through collaborative efforts with other supervisors 
and key market participants. While U.S. federal financial regulators do 
not have authority over CDS as a product, in the United Kingdom, which 
has a CDS market comparable in size to the U.S. market, FSA has 
authority over most CDS products. However, its regulatory efforts have 
generally been pursued in collaboration with U.S. regulators. 

Federal Regulation of CDS Generally Focuses on the Activities of Dealer 
Banks: 

Federal banking regulators can oversee the CDS activity of the 
financial institutions they supervise. These regulators' oversight 
captures most CDS activity because banks act as dealers in the majority 
of transactions. All of the major CDS dealers are commercial banks or 
subsidiaries of bank or financial holding companies that are subject to 
regulation by U.S. or foreign holding company regulators.[Footnote 2] 
Also, bank regulators have some authority to review the effect of a 
bank's relations with an affiliate on the health of the bank. However, 
bank regulators do not regulate the CDS markets. Moreover, bank 
regulators generally do not differentiate CDS from other types of 
credit derivatives in their supervision of institutions, because most 
credit derivatives volume is comprised of CDS. Regulators focus their 
oversight on institutions' derivatives portfolios regardless of their 
structure. 

Banking regulators' oversight of CDS activity is largely limited to 
activity that is deemed to pose risks to the safety and soundness of 
the institutions they regulate. Accordingly, federal banking regulators 
generally oversee dealer banks in the U.S. mainly as part of their 
ongoing examination programs. However, as we reported in 2008, some 
regulators continued to be concerned about the counterparty credit risk 
created when regulated financial institutions transacted with entities 
that were less regulated, such as hedge funds, because these activities 
could be a primary channel for potential systemic risk.[Footnote 3] 

FRS officials explained that when examiners identified an increasing 
use of credit derivatives at certain regulated banks, they expanded the 
scope of their examinations to include a review of risks arising from 
the banks' trading of these products. These exams generally were broad 
in scope, although occasionally they focused on CDS, and assessed the 
products' financial risk and the way banks monitored and managed that 
risk. According to officials, some of the examination findings included 
concerns related to management of counterparty credit risk, including 
collateral practices, risk management systems, models for risk 
identification, and governance issues. 

OCC officials explained that, as the prudential regulator of the large 
dealer banks, its on-site examiners conducted ongoing risk-focused 
examinations of the more complex banking activities, which could 
include CDS transactions. OCC targets its risk-focused examinations 
using risks or trends that it notices across banks. According to OCC 
officials, its on-site examiners monitor derivatives activity daily in 
the large dealer banks and look for trends and exceptions in the banks' 
information to gauge risk. For example, they may examine new 
counterparties that have not gone through an internal counterparty 
review process. OCC also conducts a quarterly analysis of the 
derivatives market using call report data submitted by all insured U.S. 
commercial banks to evaluate risks from trading activities, including 
CDS, in the national banking system. However, this oversight does not 
provide a clear snapshot of potential concentrations of risk in 
participants outside of national banks. Similarly, FRBNY collects data 
from OTC derivatives dealers that participate in an FRBNY-led 
initiative to improve the operational infrastructure for CDS, including 
information on operational metrics such as confirmation backlogs and 
transaction volumes but not on CDS exposures. 

Under consolidated supervision, some subsidiaries of holding companies 
that engage in CDS activities may not receive the same degree of 
monitoring as regulated entities receive from their prudential 
supervisors. OCC officials explained that, while most CDS activity is 
conducted in banking entities because CDS trading is a permissible bank 
activity, some derivatives activity is conducted in nonbank 
subsidiaries of holding companies. OCC, like other federal bank 
regulators, has authority to review how a bank's relations with an 
affiliate (specifically, an affiliate that is not a subsidiary of the 
bank) affects the health of the bank. However, OCC supervises the bank, 
not the affiliate. In such cases, OCC officials said that they would 
collaborate with FRS to examine activity in the other nonbank 
subsidiaries if they deemed it necessary. 

Similarly, even though SEC oversees broker-dealers, the agency does not 
regulate the CDS markets they deal in. Until September 2008, SEC 
provided oversight of major investment bank conglomerates at the 
consolidated level through its Consolidated Supervised Entity (CSE) 
program.[Footnote 4] According to SEC officials, investment banks 
generally conducted CDS transactions in subsidiaries not registered as 
U.S. broker-dealers, and therefore SEC did not have an ongoing on-site 
examination program for these entities. Rather, the CSE program 
monitored information aggregated at the holding company level that 
included the activities of these affiliates, including their CDS 
transactions. According to SEC, a significant part of the CSE 
supervision program was dedicated to monitoring and assessing market 
and credit risk exposures arising from trading and dealing activities. 
The CSE program conducted targeted exams related to three specific 
projects--reviews of liquidity pools, price verification of commercial 
real estate, and management of counterparty exposures--which SEC 
officials explained could include CDS activities but did not have CDS 
as a specific focus. 

Similarly, OTS is responsible for overseeing thrift holding companies 
through its consolidated supervision program. These entities include 
AIG, GE Capital Services, Morgan Stanley, and American Express Company, 
which are large global conglomerates with many subsidiaries. OTS does 
not conduct ongoing on-site examinations of all unregulated 
subsidiaries. OTS officials explained that the agency monitored the 
holding companies' enterprisewide risk-management practices to 
determine how the companies identified and managed risk and 
supplemented this monitoring with limited on-site visits of unregulated 
subsidiaries as it deemed necessary. For example, when AIG's external 
auditor identified internal control problems with AIG Financial 
Products, a nonthrift subsidiary that was active in the CDS market and 
ultimately identified as posing a systemic risk to the financial system 
because of its role in the market, OTS examined its operations. 
However, OTS officials told us that thrifts generally have engaged in 
limited CDS activities. 

Federal financial regulators generally supplement data from their 
supervised entities or other information they collect with data from 
sources such as the International Swaps and Derivatives Association, 
Inc. (ISDA), the Bank for International Settlements, the British 
Bankers Association, and the rating agency Fitch to compare their banks 
to the larger universe of market participants. More recently, 
information has been available to regulators from the industry's 
central trade repository, the Trade Information Warehouse (TIW). 

CDS Are Not Generally Regulated As a Product, Making Monitoring Their 
Role in the Market a Challenge: 

Federal market regulators--SEC and CFTC--do not have authority to 
regulate the CDS markets directly. With respect to CDS trading, their 
authorities are limited or restricted. In 1999, the PWG unanimously 
urged Congress to adopt recommendations aimed at mitigating certain 
legal uncertainties related to OTC derivatives. One recommendation was 
to exclude from oversight certain bilateral transactions between 
sophisticated counterparties and eliminating impediments to clearing 
OTC derivatives. A CDS is this type of transaction. Congress largely 
adopted the PWG recommendations when it passed the Commodity Futures 
Modernization Act of 2000 (CFMA). As a result, the Commodity Exchange 
Act (CEA) was amended to exclude the OTC CDS market from the regulatory 
and enforcement jurisdiction of CFTC. Federal securities laws also 
exclude CDS from SEC oversight, although SEC retains antifraud 
enforcement authority. 

SEC's authority over CDS activity conducted outside of a registered 
broker-dealer is generally limited to enforcing antifraud provisions, 
including prohibitions against insider trading. These provisions apply 
because CDS generally are considered security-based swap agreements 
under CFMA. However, because SEC is generally statutorily prohibited 
under current law from promulgating record-keeping or reporting rules 
regarding CDS trading in the OTC market outside of a registered broker- 
dealer, its ability to enforce its authority is difficult. However, in 
the past 3 years SEC has initiated a number of CDS-related enforcement 
cases for alleged violations of its antifraud prohibitions, including 
cases involving market manipulation, insider trading, fraudulent 
valuation, and financial reporting. More recently, in September 2008 
SEC initiated an investigation into possible market manipulation 
involving CDS. In connection with the investigation, SEC announced that 
it would require certain hedge fund managers and other entities with 
CDS positions to disclose those positions to SEC and provide other 
information under oath. According to SEC, depending on the results the 
investigation may lead to more specific policy recommendations 
regarding CDS. 

SEC officials indicated that investigations of OTC CDS transactions 
have been far more difficult and time-consuming than those involving 
exchange-traded equities and options because of the prohibition on 
requiring recording keeping and reporting for CDS. The lack of clear 
and sufficient record-keeping and reporting requirements for CDS 
transactions has resulted in incomplete and inconsistent information 
being provided when requested, according to SEC officials. The 
officials said that this restriction had made it more difficult to 
investigate and take effective action against fraud and manipulation in 
the CDS market than in other markets SEC oversaw. In October 2008, the 
SEC Chairman requested that Congress remove the CFMA restrictions on 
SEC's rulemaking authority with respect to CDS. The current Chairwoman 
has indicted that she supports removal of these restrictions as well. 

Federal Regulators' Approach to Monitoring Systemic Risk from CDS Has 
Hinged on Collaborative Efforts: 

Federal financial regulators have sought to address potential systemic 
threats arising from CDS activities mainly through collaborative 
efforts with other supervisors and market participants. According to 
federal financial regulators, they address potential systemic risks by 
working closely with each other and international regulators to 
exchange information and coordinate the supervision of regulated market 
participants that could pose systemic risks to the financial system. 
Some of these collaborative forums include the PWG, the Senior 
Supervisors Group, the Basel Committee on Banking Supervision, the 
Financial Stability Forum, and the Joint Forum. However, it is unclear 
to what extent the activities of unregulated subsidiaries or other 
unregulated market participants were also being reviewed as part of 
these initiatives. 

FRS officials indicated that, in carrying out its responsibilities for 
conducting monetary policy and maintaining the stability of the 
financial system, the Federal Reserve monitored markets and 
concentrations of risk through data analysis and direct contact with 
market participants. According to FRS officials, in supervising banks 
and bank holding companies they focused on CDS activity as it pertained 
to institutional stability. FRS ensures that the appropriate 
infrastructure is in place so that the system can absorb "shocks." FRS 
officials explained that, by ensuring that important market 
participants could avoid the most adverse impacts from these shocks-- 
such as through counterparty credit risk management--systemic risk 
could be mitigated. 

Over the last several years, FRS has identified opportunities to 
increase the market's resiliency to systemic shocks related to CDS--for 
example, by implementing a market process for settling CDS contracts, 
reducing the notional amounts of outstanding contracts, and improving 
the operational infrastructure of the CDS market in collaboration with 
other supervisors. For example, since September 2005 financial 
regulators in the U.S. and Europe have collaborated with the industry 
to improve the operational infrastructure of the CDS market and to 
improve counterparty risk management practices. However, some market 
participants and observers noted that the current regulatory structure 
did not enable any one regulator to monitor all market participants and 
assess potential systemic risks from CDS and other types of complex 
products. 

In the United Kingdom, FSA Generally Has Broader Authority Than U.S. 
Regulators Collectively: 

While U.S. regulators do not have authority over CDS as a product, in 
the United Kingdom, where available evidence suggests CDS volume is 
comparable to that in the United States, FSA has authority over most 
CDS products. FSA officials explained that most CDS-related regulatory 
efforts have been pursued in collaboration with U.S. regulators, such 
as the effort to improve the operational infrastructure for CDS that 
was led by FRBNY and the Senior Supervisors Group's effort to enhance 
risk management practices. FSA officials also explained that, more 
recently, it had been monitoring all aspects of OTC infrastructure and 
industry commitments, including central clearing for CDS, credit event 
settlement, collateral management processes, trade compression, and 
position transparency. Much of this monitoring is conducted through 
data collected directly from regulated firms. 

The New York State Insurance Supervisor Has a Role in Overseeing 
Insurers' CDS Activities: 

The New York State insurance supervisor also has authority to oversee 
certain aspects of insurers' OTC derivatives activities, including CDS 
transactions. According to the New York State Insurance Department, it 
has regulated the use of derivatives by insurance companies, including 
CDS, since the late 1990s. The Department is the primary regulator for 
most U.S. financial guaranty insurers (FGIs), which are also known as 
bond insurers. According to the Department, aside from FGIs few 
insurance companies buy or sell CDS because New York state law 
generally prohibits insurers from significantly leveraging their 
portfolios. Insurance companies generally use CDS for hedging credit 
risk and for investment purposes. According to department officials, in 
its role as regulator for FGIs the department ensures that insurance 
companies maintain consistent underwriting criteria and adequate 
reserves for these activities. Under New York law, insurers must file 
detailed disclosures about their derivatives transactions in their 
quarterly and annual statements. Also, prior to engaging in any 
derivatives activity insurers must file a derivatives use plan that 
documents their ability to manage derivatives transactions. According 
to department officials, the department has requested detailed 
information from FGIs and engages in ongoing dialogue with them 
concerning insurance contracts referencing CDS. 

However, if an insurance company uses subsidiaries that are not 
affiliated with the insurance company, oversight may be limited. For 
example, the superintendent of the New York State Insurance Department 
testified that it did not oversee the activities of AIG Financial 
Products because AIG Financial Products was not affiliated with the 
insurance companies the department regulates. 

Risks and Challenges Presented by CDS and Other Financial Products: 

Risks to financial institutions and markets from CDS include 
counterparty credit risk, operational risk, concentration risk, and 
jump-to-default risk. However, market participants suggested that the 
degree of risk associated with CDS varied depending on (1) the type of 
CDS, (2) the reference entity for the CDS, and (3) how the CDS was 
used. More specifically, CDS referencing ABS and CDOs, particularly 
those related to mortgages, were identified as posing greater risks to 
institutions and markets than other types of CDS. Other risks and 
challenges include the lack of transparency in CDS markets, the 
potential for manipulation related to the use of CDS as a mechanism for 
price discovery, and the use of CDS for speculative purposes. 
Regulators and market participants noted that some OTC derivatives may 
share similar risks. However, the degree of risk can vary substantially 
by product type. Equity derivatives specifically were identified as the 
OTC derivatives that were most similar to CDS in terms of the risks and 
challenges that they presented. 

Overview of the Risks and Challenges Posed by CDS: 

The main risks from CDS include counterparty credit risk, operational 
risk, concentration risk, and jump-to-default risk. In simple terms, 
counterparty credit risk is the risk to each party in an OTC 
derivatives contract that the other party will not fulfill the 
obligations of the contract. In addition to potentially not receiving 
contractual payments, a purchaser of CDS whose counterparty fails would 
suddenly be left without protection and could either have to replace 
the CDS contract at current, higher market values or go without 
protection. Banks and other financial institutions that have large 
derivatives exposures use a variety of techniques to limit, forecast, 
and manage their counterparty risk, including margin and collateral 
posting requirements. 

However, regulators, market participants, and observers identified 
several challenges in managing CDS counterparty credit risk. First, 
although margin and collateral posting serve as a primary means of 
mitigating the risk of loss if a counterparty does not perform on its 
contractual obligations, calculating margin and collateral amounts can 
be difficult because of the challenges associated with determining the 
actual amount of counterparty exposure and the value of the reference 
asset. Specifically, it may be difficult for market participants to 
agree on the valuation of CDS contracts on ABS and CDOs. Second, 
margining practices are not standardized and vary depending on the 
counterparty. For example, market participants and observers suggested 
that institutions with high credit ratings, for which exposures were 
considered to pose little credit risk, were not initially required to 
post collateral. These firms included bond insurers and AIG Financial 
Products, a noninsurance subsidiary of AIG. However, when some of these 
institutions' ratings were downgraded, the institutions had difficulty 
meeting collateral calls. Third, the CDS market lacks comprehensive 
requirements for managing counterparty credit risk. More specifically, 
the bilateral collateral and margin requirements for OTC derivatives do 
not take into account the counterparty credit risk that each trade 
imposes on the rest of the system, allowing systemically important 
exposures to build up without sufficient capital to mitigate associated 
risks. 

The second type of risk that I would like to discuss is operational 
risk. This is the risk that losses could occur from human errors or 
failures of systems or controls. With CDS, there are several 
operational steps that are required to process trades, such as trade 
confirmation, which were not automated until recently and thus created 
backlogs in the system. In a report issued in 2007, we reported that 
these backlogs were largely due to a decentralized paper-based system 
and the assignment of trades to new parties without notifying the 
original dealer--a process known as novation.[Footnote 5] For instance, 
in September 2005, some 63 percent of trade confirmations (or 97,650) 
of the 14 largest credit derivatives dealers had been outstanding for 
more than 30 days. These large backlogs of unconfirmed trades increased 
dealers' operational risk, because having unconfirmed trades could 
allow errors to go undetected that might subsequently lead to losses 
and other problems. Potential problems also existed in the operational 
infrastructure surrounding physical settlement, novation, and valuation 
of CDS. 

The third type of risk, concentration risk, refers to the potential for 
loss when a financial institution establishes a large net exposure in 
similar types of CDS. For example, AIG presented concentration risk 
because it sold a significant amount of CDS protection on related 
reference entities without also holding offsetting positions and did 
not sufficiently manage this risk. This risk tends to be greater for 
dealers that sell CDS protection because no margin and collateral 
requirements exist to ensure that the selling firm will be able to meet 
its potential obligations. Also, the potential exposures are greater 
and more uncertain than the fixed premium payments of a purchaser of 
CDS protection. Additionally, if a market participant decides to hold a 
large concentrated position, it could experience significant losses if 
a credit event occurred for one or more reference entities. But 
concentration risk can create problems for market participants even 
without a credit event involving the reference entity. For example, a 
market participant may face obligations to post collateral on a large 
net exposure of CDS if its financial condition changes, potentially 
resulting in financial distress for the dealer. AIG is the most recent 
example of this problem. When its credit rating was downgraded, the 
contracts required that it post collateral, contributing to the 
company's liquidity crisis. 

Market participants suggested that the degree of risk from concentrated 
net exposures was tied to the nature of the reference entity or 
obligation. For example, a concentrated position in CDS on mortgage- 
related CDOs may present more risk than CDS on a highly-rated 
corporation or U.S. government bonds. Further, concentration risks at 
one firm may also present challenges to other market participants and 
the financial system. According to a regulator and an observer, the 
lack of clear information on the net CDS exposures of market 
participants makes informed decisions about risk management difficult, 
a situation that becomes increasingly problematic when a credit event 
occurs. A regulator also testified that because the CDS market was 
interconnected, the default of one major participant increased the 
market and operational risks faced by more distant financial market 
participants and impacted their financial health. The near-collapse of 
AIG illustrates the risk from large exposures to CDS. 

Finally, jump-to-default risk, as it relates to the CDS market, is the 
risk that the sudden onset of a credit event for the reference entity 
can create an abrupt change in a firm's CDS exposure. Such a credit 
event can result in large swings in the value of the CDS and the need 
to post large and increasing amounts of collateral and ultimately fund 
the settlement payment on the contact. The default of a reference 
entity could put capital strain on the CDS seller from increased 
collateral and payment obligations to settle the contract. For example, 
because CDS generally are not funded at initiation, a CDS seller may 
not have provided sufficient collateral to cover the settlement 
obligations. 

CDS Can Also Pose a Number of Other Risks and Challenges: 

Other risks and challenges from CDS identified by market participants, 
observers, and regulators include a lack of transparency in the CDS 
market, the potential for manipulation related to the use of CDS as a 
price discovery mechanism, and the use of CDS for speculative purposes. 
According to some regulators, market participants, and observers, 
limited transparency or disclosure of CDS market activity may have 
resulted in the overestimation of risk in the market. Such a lack of 
transparency may have compounded market uncertainty about participants' 
overall risk exposures, the concentration of exposures, and the market 
value of contracts. For example, as mentioned previously at least one 
regulator and an observer suggested that it was unclear how the 
bankruptcy of Lehman Brothers would affect market participants, and 
this uncertainty contributed to a deterioration of market confidence. 
More specifically, it was reported that up to $400 billion of CDS could 
be affected, but the Depository Trust and Clearing Corporation (DTCC) 
later stated that its trade registry contained $72 billion of CDS on 
Lehman, and this amount was reduced to about $21 billion in payments 
after bilateral netting. Some market participants suggested that 
concerns about transparency were even more prevalent with customized 
CDS products because the contracts were not standardized and their 
prices were determined using estimates rather than prices from actual 
transactions. 

Some regulators and an industry observer suggested the potential 
existed for market participants to manipulate these prices to profit in 
other markets that CDS prices might influence, such as the equity 
market, and that the lack of transparency could contribute to this 
risk. CDS price information is used by some market participants as an 
indicator of a company's financial health. Market participants use 
spreads on CDS contracts to gauge the financial health and 
creditworthiness of a firm. However, two regulators and an industry 
observer suggested that it was unclear whether CDS prices accurately 
reflected creditworthiness because the market was largely unregulated 
and the quality of data is questionable in an opaque market. According 
to testimony by an SEC official in October and November 2008, the lack 
of transparency in the CDS market also created the potential for fraud, 
in part because the reporting and disclosure of trade information to 
the SEC was limited. More specifically, the official testified that a 
few CDS trades in a relatively low-volume or thin market could increase 
the price of the CDS, suggesting that an entity's debt was viewed by 
the market as weak. Because market participants may use CDS as one of 
the factors in valuing equities, this type of pricing could adversely 
impact a reference entity's share price. One market observer we spoke 
with offered the following hypothetical example: if the CDS price moves 
up and the equity price moves down, an investor could profit from 
holding a short position in the equity by buying protection in the CDS 
market. The SEC official testified that a mandatory system of record 
keeping and reporting of all CDS trades to SEC should be used to guard 
against the threat of misinformation and fraud by making it easier to 
investigate these types of allegations. However, another regulator 
suggested that the price discovery role was not a unique role to CDS 
and that exchange-traded derivatives such as foreign exchange and 
interest rate derivatives also served a price discovery function. 

Another challenge identified by regulators and market participants was 
the frequent use of CDS for speculative purposes, an issue that has 
raised some concerns among some regulators and industry observers. Some 
have suggested that the practice should be banned or in some way 
restricted. However, other regulators and market participants disagree 
and note that speculators in the CDS market provide liquidity to the 
market and facilitate hedging. Many of the concerns stem from uncovered 
or "naked" CDS positions, or the use of CDS for speculative purposes 
when a party to a CDS contract does not own the underlying reference 
entity or obligation. Because uncovered CDS can be used to profit from 
price changes, some observers view their function as speculation rather 
than risk transfer or risk reduction. For example, one regulatory 
official stated that these transactions might create risks, because 
speculative users of CDS have different incentives than other market 
participants. In addition, one regulator stated that when participants 
used CDS for speculative purposes, there was no direct transfer or swap 
of risk. Instead, the transaction creates risk from which the 
participant aims to profit. Market participants also noted that the 
risks associated with CDS did not stem from their use for speculation 
but from a failure to manage the risks, particularly CDS of ABS. Market 
participants and an observer also explained that a restriction on 
uncovered CDS would create a market bias in favor of protection buyers, 
because it is easier for them to hold a covered position. This bias 
could impact the liquidity of the market, because trading would be 
confined to those with an exposure to the referenced entity. Finally, 
market participants noted that firms used CDS to manage risks from many 
economic exposures in addition to risks such as counterparty credit 
exposures that arise from holding the underlying reference obligation. 

A Number of Other OTC Derivatives Pose Similar Risks and Challenges: 

In addition to CDS, we also explored whether other products posed 
similar risks and challenges. Regulators and market participants 
identified a number of other OTC derivatives that presented similar 
risks and challenges, such as counterparty credit risk and operational 
risk. These OTC derivative products include interest rate, foreign 
exchange, and commodity derivatives. While the types of risk may be 
similar, the degree of risk can vary. However, equity derivatives 
specifically were identified as the OTC derivatives that are most 
similar to CDS in terms of the risks and challenges that they 
presented. OTC equity derivatives, such as equity swaps and options, 
were said to be similar to CDS because of the potential for abrupt 
shifts in exposure, a lack of transparency, and the ability to 
customize the product. Nevertheless, according to regulators and 
industry observers, the CDS market differs from other OTC derivatives 
markets because it poses greater risks due to the potential for greater 
increases in payment obligations and larger impacts from life-cycle 
events such as those associated with jump-to-default risk. 

Regulators and the Industry Have Undertaken a Number of Initiatives 
Recently to Address Risks Posed By CDS and Other Financial Products: 

Financial regulators and the industry have initiated several efforts to 
begin addressing some of the most important risks posed by CDS and 
similar products, particularly operational and counterparty credit 
risks. These efforts include improving the operational infrastructure 
of CDS markets, implementing a clearinghouse or central counterparty to 
clear CDS trades, and establishing a central trade registry for CDS. If 
implemented effectively and sustained, the recent initiatives could 
begin to address some of the risks related to the use of CDS. However, 
their effectiveness will likely be constrained by two factors. First, 
participation in a clearinghouse and central trade registry is 
generally voluntary. And second, the efforts would not include the more 
customized and highly structured CDS that can include CDS on complex 
reference entities that may pose significant risks to institutions and 
financial markets. A number of other reforms to the CDS market have 
surfaced but face challenges. These include mandatory clearing or 
restricting CDS trades. Finally, OTC derivatives that share some of the 
risks related to CDS could benefit from similar efforts to mitigate 
their impact. 

Actions Associated with Managing Risks Related to CDS Have Focused on 
Three Areas: 

Financial regulators and market participants have recently taken steps 
to try to address risks posed by CDS. The efforts have focused on three 
main areas: (1) operational and infrastructure improvements, (2) 
creation of a central trade repository, and (3) development of 
clearinghouses to clear CDS contracts. 

Operational and Infrastructure Improvements: 

Regulators and industry members have cooperated since 2005 on four 
projects to identify and address operational risks posed by CDS. In 
addition to managing operational risks from CDS, several of these 
efforts should assist participants in managing counterparty credit 
risks in general. 

* First, the industry has worked to reduce the backlog of CDS 
processing events, including unconfirmed trades. In 2005, a joint 
regulatory initiative involving U.S. and foreign regulators directed 
major CDS dealers to reduce the backlog of unconfirmed trades and 
address the underlying causes of these backlogs. In response, market 
participants increased the use of electronic confirmation platforms. 
Since November 2006, most CDS trades are confirmed electronically 
through an automated confirmation system known as Deriv/Serv. By 
increasing automation and requiring end users to obtain counterparty 
consent before assigning trades, dealers were able to significantly 
reduce the number of total confirmations outstanding. As a result of 
these efforts to improve trade processing, many participants view the 
CDS market as the most automated among OTC derivatives. 

* Second, the industry has sought to improve novation, the process 
whereby a party to a CDS trade transfers, or assigns, an existing CDS 
obligation to a new entity. In 2005, the joint regulatory initiative 
suggested that the novation process had contributed to the large 
backlog of unconfirmed trades, because the assignment of trades to new 
parties often occurred without the consent of the original 
counterparty. In such cases, a party to a CDS contract might not be 
aware of the identity of its new counterparty, possibly increasing 
operational and counterparty credit risks. To streamline the novation 
process, ISDA introduced a novation protocol in 2005 that required 
counterparty consent before assigning a trade. However, until recently 
parties to the novation communicated using phone and e-mail, both of 
which can be inaccurate and inefficient. More recently, the industry 
has committed to processing all novation consents for eligible trades 
through electronic platforms. 

* Third, the industry has attempted to reduce the amount of outstanding 
trades via "portfolio compression." In 2008, a Federal Reserve 
initiative resulted in a working group of dealers and investors that 
collaborated with the industry trade group ISDA to pursue portfolio 
compression of CDS trades. The process involves terminating an existing 
group of similar trades and replacing them with fewer "replacement 
trades" that have the same risk profiles and cash flows as the initial 
portfolio, and thus eliminating economically redundant trades. 
According to FRBNY, the compression of CDS trades results in lower 
outstanding notional amounts and helps to reduce counterparty credit 
exposures and operational risk. By the end of October 2008, FRBNY 
reported that trade compression efforts had reduced the notional amount 
of outstanding CDS by more than one-third. 

* Finally, the industry has taken steps to implement a cash settlement 
protocol for CDS contracts. CDS contracts traditionally used physical 
settlement that required a protection buyer to deliver the reference 
obligation in order to receive payment. Because many CDS are uncovered, 
the protection buyer would have to buy the underlying referenced entity 
to deliver, potentially causing buyers to bid up prices and limiting 
the profits from protection and speculation. To address this concern, 
ISDA developed protocols to facilitate cash settlement of CDS 
contracts. The cash settlement protocols rely on auctions to determine 
a single price for defaulted reference obligations that is then used to 
calculate payout amounts to be paid at settlement. This process has 
been used to settle CDS contracts involved in recent credit events, 
including Lehman Brothers, Washington Mutual, Fannie Mae, and Freddie 
Mac. 

Creation of a Central Trade Repository Illustrates the Limits of a 
Voluntary System: 

In November 2006, DTCC created the TIW to serve as the industry's 
central registry for CDS. TIW contains an electronic record of most CDS 
trades, and DTCC and market participants plan to increase its coverage. 
In addition to placing most new trades in TIW, CDS dealers and other 
market participants also plan to submit existing and eligible CDS 
trades to TIW. 

TIW helps to address operational risks and transparency concerns 
related to the CDS market. For example, according to DTCC, it helps 
mitigate operational risk by reducing errors in reporting, increases 
transparency by maintaining up-to-date contract information, promotes 
the accuracy of CDS-related information, and simplifies the management 
of credit events. TIW also facilitates operational improvements such as 
automated life-cycle processing by interacting with electronic 
platforms for derivatives trades such as Deriv/Serv. 

Additionally, TIW should assist regulators in monitoring and managing 
concentration risk from CDS. Although regulators can receive CDS- 
related information from their regulated entities, no regulator has the 
ability to receive this information from all market participants, and 
no single comprehensive source of data on the CDS market exists. 
However, a central trade repository that contains information on all 
CDS trades will allow regulators to monitor large positions of market 
participants and identify large and concentrated positions that may 
warrant additional attention. TIW also has helped to address some 
concerns about CDS market transparency by providing aggregate 
information on CDS trades. The information includes gross and net 
notional values for contracts on the top 1,000 underlying CDS single- 
name reference entities and all indexes and is updated weekly. 

Despite the important benefits provided by TIW, several factors limit 
its usefulness as a tool to monitor the overall market. First, TIW does 
not include all CDS trades, particularly those that cannot be confirmed 
electronically. For example, TIW cannot fully capture all customized 
trades, such as CDS referencing ABS and CDOs, including those related 
to mortgages. While DTCC officials believed that TIW includes a large 
portion of CDS trades, they noted that they could not be certain 
because the size and composition of the entire market remain unknown. 
Second, TIW currently has no regulatory oversight to ensure the quality 
of the data, and regulators lack the authority to require that all 
trades be included in TIW, particularly those of nonbanks. 

Clearinghouses May Offer Some Benefits, but Some CDS May Be Too 
Customized for Clearing: 

A clearinghouse can reduce risks associated with CDS, including 
counterparty credit risks, operational risks, and concentration risks, 
while also improving transparency. A clearinghouse acts as an 
intermediary to ensure the performance of the contracts that it clears. 
For CDS, market participants would continue to execute trades as 
bilateral OTC contracts. However, once registered with the 
clearinghouse the CDS trade would be separated into two contracts, with 
the clearinghouse serving as the counterparty in each trade. That is, 
the clearinghouse would have a separate contractual arrangement with 
both counterparties of the original CDS contract and serve as the 
seller to the initial buyer and the buyer to the initial seller. In 
this way, a clearinghouse would assume the counterparty credit risk for 
all of the contracts that it cleared. 

If a clearinghouse is well-designed and its risks are prudently 
managed, it can limit counterparty credit risk by absorbing 
counterparty defaults and preventing transmission of their impacts to 
other market participants. Clearinghouses are designed with various 
risk controls and financial resources to help ensure that they can 
absorb counterparty failures and other financial losses. For example, 
clearinghouses impose standard margin requirements and mark positions 
to market on a daily basis. They also have other financial safeguards 
that typically include capital requirements, guaranty funds, backup 
credit lines, and the ability to call on capital from member firms, 
which often are large financial institutions. 

A clearinghouse also can help to standardize margin and collateral 
requirements. It can impose more robust risk controls on market 
participants and assist in the reduction of CDS exposures through 
multilateral netting of trades. In doing so, it would facilitate the 
compression of market participants' exposures across positions and 
similar CDS products, thereby reducing the capital needed to post 
margin and collateral. 

A clearinghouse also can help to address operational and concentration 
risks and improve CDS transparency. Market participants suggested that 
a clearinghouse would help to centralize market information and could 
facilitate the processing of CDS trades on electronic platforms. It can 
also help limit concentration risk through standardized requirements 
for margin collateral that may help reduce the leverage imbedded in CDS 
contracts and thus place limits on a firm's ability to amass a large 
net exposure selling CDS. Finally, according to some regulators and 
prospective clearinghouses, a clearinghouse could improve CDS 
transparency by releasing information on open interest, end-of-day 
prices, and trade volumes. 

However, like the other options for improving the CDS market, only 
certain standardized trades would be cleared by a clearinghouse, and 
market participants would decide which trades to submit for clearing. A 
clearinghouse can only clear trades with a sufficient level of 
standardization because the more customized the contract, the greater 
the risk management and operational challenges associated with clearing 
it. Initially, the proposed clearinghouses will clear standard-index 
CDS and some highly traded single-name corporate CDS. Regulators and 
market participants suggested that risks from more complex and 
structured CDS would have to be addressed outside of clearinghouses. 
One market participant volunteered that it would not be opposed to 
collateral requirements for CDS that were not cleared through a 
clearinghouse. Further, because clearing is voluntary, it is unclear 
what portion of CDS will be cleared and whether this volume will be 
sufficient to support the clearinghouses. 

Regulators and market participants suggested that robust risk 
management practices were critical for clearinghouses because 
clearinghouses concentrated counterparty credit and operational risk 
and CDS presented unique risks. Failure to sufficiently manage these 
risks could threaten the stability of financial markets and major 
institutions if a clearinghouse were to fail. In addition, if jump-to- 
default risk is not sufficiently managed through margin requirements 
and other methods, it has the potential to create significant losses 
for the clearinghouses. According to market participants, the jump-to- 
default risk posed by CDS makes determining sufficient margin 
requirements difficult. If a required level of margin is considered too 
high, whether justified or not, market participants may be less likely 
to use the clearinghouse. 

Although several groups have announced plans to create clearinghouses 
for CDS, none of the groups currently are clearing trades. First, as 
part of their efforts over the past year to improve the CDS market, 
FRBNY and several other regulators encouraged the industry to introduce 
central clearing of CDS contracts. The industry previously had begun 
moving toward the creation of a clearinghouse, and in July 2008, after 
FRBNY encouraged firms to develop clearinghouse proposals, several 
major dealers committed to launching a clearinghouse by December 2008. 
None are currently operational, however.[Footnote 6] At least four 
groups have developed clearinghouse options for CDS, two in the United 
States (Intercontinental Exchange and CME Group) and two in Europe 
(LIFFE and Eurex Clearing). LIFFE opened for clearing in December 2008 
but has had virtually no business as of February 2009. 

Market participants and regulators identified advantages and 
disadvantages associated with having multiple clearinghouses clear CDS 
contracts. Some regulators noted that there could be advantages to 
having multiple clearinghouses at the early stages of development, 
particularly related to competition in designing and developing them. 
In addition, one market participant noted that with multiple 
clearinghouses the concentration of risk could be spread across 
multiple platforms. However, market participants suggested that having 
multiple clearing houses raised concerns about regulatory consistency 
in terms of setting standards and monitoring, especially for those in 
the U.S. and internationally. Market participants also indicated that 
multiple clearinghouses would create inefficiencies and remove some of 
the advantages gained from multilateral netting, because no single 
clearinghouse would enjoy the benefit of a complete portfolio of CDS. 
Moreover, participants would have to post collateral in multiple 
venues. 

Under current law, a clearing organization for CDS--or other OTC 
derivatives--must be regulated, but any of several regulators may 
provide that oversight.[Footnote 7] FRS, CFTC, and SEC all have played 
a role in establishing a clearinghouse, including reviewing proposals 
seeking regulatory approval. CME is registered as a derivatives 
clearing organization with CFTC. ICE has established its clearinghouse 
in a subsidiary FRS member bank--ICE Trust. LIFFE is regulated by FSA, 
and Eurex is overseen by the German Federal Financial Supervisory 
Authority. 

SEC has determined that the act of clearing CDS through a clearinghouse 
may result in the contracts being considered securities subject to the 
securities laws. To facilitate the clearing and settlement of CDS by 
clearinghouses, SEC issued an interim final rule on temporary and 
conditional exemptions in January 2009. SEC stated that the conditions 
of these exemptions would allow the agency to oversee the development 
of the centrally cleared CDS market and CDS exchanges and to take 
additional action as necessary. SEC has determined that LIFFE has met 
the conditions for the temporary exemptions from registration under the 
securities laws. The exemption expires in September 2009, at which time 
SEC officials believe they will be better situated to evaluate how 
these exemptions apply to the cleared CDS market. 

Given the overlapping jurisdiction and lack of regulatory clarity, FRS, 
CFTC, and SEC have signed a memorandum of understanding to ensure that 
each regulator applies similar standards across the different 
clearinghouse efforts. According to the regulators, the purpose of the 
memorandum is to foster cooperation and coordination of their 
respective approvals, ongoing supervision, and oversight of 
clearinghouses for CDS. Moreover, some said that the memorandum would 
help to prevent an individual regulator from taking a softer approach 
in its monitoring and oversight of required standards for 
clearinghouses, which could encourage more participants to use the less 
rigorously regulated clearinghouse. However, another regulator 
suggested that the memorandum still might not guarantee consistent 
application of clearinghouse standards and requirements, because each 
regulator had a different mission and approach to regulation. 

Market participants identified several disadvantages related to the 
current state of oversight for clearinghouses. Some market participants 
suggested that there had been a lack of clarity and certainty regarding 
oversight of clearinghouses because of the involvement of multiple 
regulators. As noted, some market participants questioned whether 
consistent standards and oversight would be applied across 
clearinghouses. Market participants and one regulator noted the 
importance of coordinating oversight internationally to ensure 
consistent global standards and mitigate the potential for regulatory 
arbitrage. Finally, some market participants suggested that having 
multiple regulators for a clearinghouse created the potential for 
regulatory overlap and related inefficiencies. 

Other Ideas to Manage CDS Risks: 

Market observers and others have proposed other ideas to address 
concerns related to CDS, including (1) mandatory clearing, (2) 
mandatory exchange trading, (3) a ban on uncovered CDS, and (4) 
mandatory reporting of CDS trades. While these proposals would address 
some perceived problems with CDS markets, sources we interviewed 
identified important limitations and challenges for each of them. 

* Mandatory clearing would ensure that CDS contracts benefited from the 
advantages of a clearinghouse, but regulators, market participants, and 
market observers explained that highly customized CDS would be 
impossible to clear because they lack the needed standardization. 

* Mandatory exchange trading could offer improved price transparency 
and the benefits of clearing. But some market observers indicated that 
some CDS that were illiquid could not support an exchange and that the 
standardization of contracts would limit CDS' risk management benefits. 

* Banning or otherwise restricting uncovered CDS could limit activity 
that some observers believe contributed to the recent distress of 
financial institutions, yet proponents of uncovered CDS argue that 
banning these contracts would severely limit market liquidity and 
eliminate a valuable tool for hedging credit risk. 

* Finally, some regulators and market observers believe that mandatory 
reporting of CDS trades to a central registry would increase 
transparency and provide greater certainty that information on all CDS 
was being captured in one place. However, some market participants 
suggested that detailed reporting of CDS trades should be limited to 
regulators so that positions were not exposed publicly, and some 
participants explained that a similar reporting system for bond markets 
had had adverse consequences that stifled that market. 

Other OTC Derivatives May Benefit from Similar Efforts: 

Regulators and the industry have initiated efforts to improve the 
operational infrastructure of OTC derivatives in general. However, each 
product has unique challenges because of differences in market 
maturity, volumes, and users, among other things. Despite these unique 
challenges, regulators, market participants, and observers told us that 
OTC derivatives, generally shared similar risks, such as operational 
and counterparty credit risks, and would benefit from initiatives to 
address those risks. As part of their efforts to improve the 
operational infrastructure of OTC derivatives markets, market 
participants have identified seven high-level goals: 

* Global use of clearinghouse processing and clearing, 

* Continuing portfolio compression efforts, 

* Electronic processing of eligible trades (targets of the effort 
include equity, interest rate, and foreign exchange derivatives), 

* Elimination of material confirmation backlogs, 

* Risk mitigation for paper trades that are not electronically 
processed, 

* Streamlined trade life-cycle management, and: 

* Central settlement for eligible transactions. 

Some other OTC derivatives may also benefit from reductions in the 
amount of outstanding trades through portfolio compression efforts. 
FRBNY officials stated that they are looking at other OTC derivatives 
that had a critical mass of outstanding trades to determine whether 
they would benefit from compression. To the extent that further 
regulatory actions are explored for other OTC derivatives, regulators 
must consider the risks and characteristics of each class of OTC 
derivatives before taking additional actions. 

In closing, I would like to provide some final thoughts. While CDS have 
received much attention recently, the rapid growth in this type of OTC 
derivative more generally illustrates the emergence of increasingly 
complex products that have raised regulatory concerns about systemic 
risk. Bank regulators may have some insights into the activities of 
their supervised banks that act as derivatives dealers, but CDS, like 
OTC derivatives in general, are not regulated products, and the 
transactions are generally not subject to regulation by SEC, CFTC, or 
any other U.S. financial regulator. Thus, CDS and other OTC derivatives 
are not subject to the disclosure and other requirements that are in 
place for most securities and exchange-traded futures products. 
Although recent initiatives by regulators and industry have the 
potential to address some of the risks from CDS, these efforts are 
largely voluntary and do not include all CDS contracts. In addition, 
the lack of consistent and standardized margin and collateral practices 
continue to make managing counterparty credit risk and concentration 
risk difficult and may allow systemically important exposures to 
accumulate without adequate collateral to mitigate associated risks. 
This area is a critical one and must be addressed going forward. 

The gaps in the regulatory oversight structure of and regulations 
governing financial products such as CDS allowed these derivatives to 
grow unconstrained, and little analysis was done on the potential 
systemic risk created by their use. Regulators of major CDS dealers may 
have had some insights into the CDS market based on their oversight of 
these entities, but they had limited oversight of nonbank market 
participants, such as hedge funds, or subsidiaries of others like AIG, 
whose CDS activities partly caused its financial difficulties. This 
fact clearly demonstrates that risks to the financial system and even 
the broader economy can result from institutions that exist within the 
spectrum of supervised entities. Further, the use of CDS creates 
interconnections among these entities, such that the failure of any one 
counterparty can have widespread implications regardless of its size. 
AIG Financial Products, which had not been closely regulated, was a 
relatively small subsidiary of a large global insurance company. Yet 
the volume and nature of its CDS business made it such a large 
counterparty that its difficulty in meeting its CDS obligations not 
only threatened the stability of AIG but of the entire financial system 
as well. 

Finally, I would briefly like to mention what the current issues 
involving CDS have taught us about systemic risk and our current 
regulatory system. The current system of regulation lacks broad 
authority to monitor, oversee, and reduce risks to the financial system 
that are posed by entities and products that are not fully regulated, 
such as hedge funds, unregulated subsidiaries of regulated 
institutions, and other non-bank financial institutions. The absence of 
such authority may be a limitation in identifying, monitoring, and 
managing potential risks related to concentrated CDS exposures taken by 
any market participant. Regardless of the ultimate structure of the 
financial regulatory system, a systemwide focus is vitally important. 
The inability of the regulators to monitor activities across the market 
and take appropriate action to mitigate them has contributed to the 
current crisis and the regulators' inability to effectively address its 
fallout. Any regulator tasked with a systemwide focus would need broad 
authority to gather and disclose appropriate information, collaborate 
with other regulators on rule making, and take corrective action as 
necessary in the interest of overall financial market stability, 
regardless of the type of financial product or market participant. 

Staff Contact and Acknowledgments: 

For further information about this testimony, please contact Orice M. 
Williams on (202) 512-8678 or at williamso@gao.gov. Contact points for 
our Offices of Congressional Relations and Public Affairs may be found 
on the last page of this statement. Individuals making key 
contributions to this testimony include Karen Tremba, Assistant 
Director; Kevin Averyt, Nadine Garrick, Akiko Ohnuma, Paul Thompson, 
and Robert Pollard. 

[End of section] 

Footnotes: 

[1] GAO, Financial Regulation: A Framework for Crafting and Assessing 
Proposals to Modernize the Outdated U.S. Financial Regulatory System, 
[hyperlink, http://www.gao.gov/products/GAO-09-216] (Washington, D.C.: 
Jan. 8, 2009). 

[2] Some CDS activities are conducted at these banks' broker-dealer 
subsidiaries, which are subject to SEC oversight. 

[3] GAO, Hedge Funds: Regulators and Market Participants Are Taking 
Steps to Strengthen Market Discipline, but Continued Attention Is 
Needed, [hyperlink, http://www.gao.gov/products/GAO-08-200] 
(Washington, D.C.: Jan. 24, 2008). 

[4] The investment bank conglomerates formerly regulated under SEC's 
CSE program are now supervised at the consolidated level as bank 
holding companies. The CSE program no longer exists, although SEC 
continues to oversee these firms' registered broker-dealer 
subsidiaries. 

[5] GAO, Credit Derivatives: Confirmation Backlogs Increased Dealers' 
Operational Risks, but Were Successfully Addressed after Joint 
Regulatory Action, [hyperlink, http://www.gao.gov/products/GAO-07-716] 
(Washington, D.C.: June13, 2007). 

[6] The U.S.-based clearinghouses are still awaiting regulatory 
approval. 

[7] Section 409 of the Federal Deposit Insurance Corporation 
Improvement Act of 1991, as added by CFMA, requires that a multilateral 
clearing organization for OTC derivatives be (1) either a bank subject 
to federal supervision, (2) registered with CFTC or SEC, or (3) 
supervised by an approved foreign financial regulator. 

[End of section] 

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