Treasury Announces CDS Policy Objectives

Treasury has announced:

the development of credit default swap central counterparties, some of which will commence operations before the end of 2008, and the establishment of a Memorandum of Understanding regarding CDS central counterparties among the Federal Reserve Board of Governors, the Securities and Exchange Commission and the Commodity Futures Trading Commission. The PWG also announced a broad set of policy objectives to guide efforts to address the full range of challenges associated with OTC derivatives and issued a progress summary to provide an overview of the results of ongoing efforts to strengthen the infrastructure of OTC derivatives markets.

The [Presidential Working Group]’s top near-term OTC derivatives priority is to oversee the successful implementation of central counterparty services for credit default swaps. A well-regulated and prudently managed CDS central counterparty can provide immediate benefits to the market by reducing the systemic risk associated with counterparty credit exposures. It also can help facilitate greater market transparency and be a catalyst for a more competitive trading environment that includes exchange trading of CDS.

Much of the announcement simply represents Treasury’s imprimatur on the New York Fed’s announces of Big Developments in the CDS Market.

There is more meat in the Statement of Policy Objectives, most important of which is:

Improve Market Transparency and Integrity for Credit Default Swaps
• Public reporting of prices, trading volumes and aggregate open interest should be required to increase market transparency for participants and public.
• Regulators should have access to trade and position information housed at central counterparties (CCPs) and central trade repositories for the purpose of monitoring market trends, identifying potential issues, and preventing market manipulation and insider trading.

Now, these are worthy objectives for investors, but will make the market a lot less profitable for dealers. Profitability in the Eurobond market, for instance, plunged in 1988 (or thereabouts) when Bloomberg became pervasive and prices of various bonds became public knowledge. In a large part, this increase in market efficiency simply highlights gross incompetence in the buy-side community, but nevertheless the effect is real.

However, a more important consideration is: can the US enforce these policy objectives, or will the market simply move to Dubai? You only get to make the rules if you control the game.

I’ll bet that the US still has the influence to enforce the stated policy objectives … but I’ll also bet that the Next Big Thing will come out of a relatively unregulated environment – investors in such places own a huge chunk of the Street at this point – and the US will find that he who has the gold, makes the rules.

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