Security Industry News
June 10, 2009
By Shane Kite
 
A “liquidity” test should define whether a credit default swap (CDS) will be considered “standardized” or “customized,” a split which will determine how the contracts will be treated under upcoming derivatives regulations, Robert Pickel, CEO of the International Swaps and Derivatives Association (ISDA), told the House Financial Services subcommittee on June 9.
 
“I think the question of where a product is in the standardization process is largely a function of how actively traded and how liquid the underlying market is,” Pickel said. “Liquidity I think largely drives where the dividing line would be. But that’s not an easy determination to make.”
 
Pickel was describing the potential test during an extended Q&A session with Rep. Judy Biggert regarding methods for “effective” regulation of the over-the-counter (OTC) derivatives sector.
 
The standard and custom definitions are important because they will determine how much of the market will end up getting centrally cleared and traded electronically. Only “custom” products would be kept privately traded, with details delivered afterward to a trade repository for regulator monitoring.
 
Neither Treasury nor the industry has defined exactly what “custom” and “standard” should mean. In the meantime, exchanges, inter-dealer brokers and big banks are all jockeying to bolster or boost market share as rules shift.
 
Discussions on CDS specifications are ongoing with the Obama administration, Pickel said. The talks stem from the Treasury Department’s May 13 proposal to require central clearing and electronic trading for all standard contracts and mandated reporting of trade details for all custom contracts.
 
Upcoming requirements could vary based on three types of CDS. For example, Biggert asked if legislators should specify “three buckets” of OTC products in writing new rules for the market, where some would be required to be electronically traded, another portion cleared and a third -- custom trades -- sent to a database for regulators to audit.
 
“I think that is a very good division of how this market will evolve and is already in the process of evolving,” Pickel said. “You would have an exchange traded or perhaps an electronically traded element that would allow the highly standardized trades to be traded that way, you would have this category of cleared trades and you would have the customized products.”
 
Protocols could also determine requirements: ISDA has developed a set of standard trading protocols for swaps linked to corporate debt, although the trade group has yet to standardize contracts linked to loans, mortgages or asset-backed securities (ABS).
 
Subcommittee members were cautioned at the hearing by banks, exchanges and inter-dealer brokers to refrain from making rules that would mandate clearing or require exchange or electronic trading for credit default swaps and other OTC derivatives, because they said it would make it expensive for companies to hedge their risk and thus push the derivatives market offshore or outside the U.S.

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