The CDS market’s size has halved from $64 trillion to $31 trillion in three months. But finally, we’re told, the much-needed central clearinghouse for this market is being built:

 New York approved Intercontinental Exchange Inc.’s application to form a state-regulated trust to guarantee trades in the $31 trillion credit-default swap market, boosting the company’s bid to beat rival CME Group Inc. in running a clearinghouse for the trades.

The state Banking Department approved the application after a meeting today, Chairman Richard Neiman said in a statement. The approval paves the way for Intercontinental, the second-largest U.S. futures exchange also known as ICE, to raise capital to fund the clearinghouse, according to the statement. ICE U.S. Trust LLC, as the subsidiary is known, still needs regulatory approval from the Federal Reserve.

“We have worked closely with our counterparts at the Federal Reserve Bank of New York in overseeing this industry initiative,” Neiman said in the statement. A clearinghouse for CDS contracts will “reduce systemic risk” within the banking industry, he said.

The Fed has been pushing for a clearinghouse after Lehman Brothers Inc., one of the largest dealers in the CDS market, went bankrupt in September, threatening the stability of its trading partners. A clearinghouse, capitalized by its members, all but eliminates counterparty default risk by becoming the buyer for every seller and the seller for every buyer.

CME Group

Chicago-based CME Group, the world’s largest futures market, is seeking to use its existing clearinghouse to back CDS trades. It still requires regulatory approval from the Commodity Futures Trading Commission, as well as license agreements from Markit Group Ltd., which owns the most used CDS indexes and pricing systems.

A clearinghouse owner could earn between $100 million and $400 million a year in revenue from clearing CDS trades, according to estimates by Wachovia Capital Markets and Keefe Bruyette & Woods Inc.

NYSE Euronext and Eurex AG are also seeking to clear CDS trades. ICE earlier this year said it will buy the Clearing Corp., the clearinghouse owned by banks including Goldman Sachs Group Inc. and JPMorgan Chase & Co., to secure commitments from nine dealers in the CDS market to participate in its plan.

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