NEW YORK/LONDON The race for rights to set up a regulated and exchange-based market for credit default swaps is being led by CME Group , but the final decision will be a trade off between urgency and politics.
The $55 trillion market, vilified as a major contributor to the current financial crisis, is heading for much tighter regulation and a number of exchanges are vying for a piece of this potentially lucrative business.
Aside from CME, which runs the Chicago Mercantile Exchange, rival pitches have come from the derivatives arms of both Deutsche Boerse (DB1Gn.DE) and NYSE Euronext NYX.N, as well as a promising joint venture between IntercontinentalExchange (ICE.N) and The Clearing Corporation, which is owned by a group of major CDS dealers.
U.S. and European regulators are desperate to avoid another meltdown like the one which forced the $85 billion U.S. government bailout of insurer AIG.
They adamantly want concrete proposals by the end of this year on central clearing for such derivatives to rein in counterparty risk.
The world's major CDS dealers -- who dominate this over-the-counter market but were badly shaken by the failure of Wall Street's investment banking model -- are generally lined up behind The Clearing Corporation.
That proposal, which includes a trading platform operated by IntercontinentalExchange Inc (ICE.N), would largely keep the CDS market in dealers' hands.
But the launch of TCC's platform was delayed even before September's market disruption, opening the door for the CME, which says it's joint proposal with Chicago-based hedge fund Citadel Investment Group can produce a CDS exchange by early next month.
"If the dealer community drags its feet then I think the regulators will step in and say 'tough luck'," said Patrick O'Shaughnessy, exchanges analyst at Raymond James in Chicago.
"CME Group is better-positioned if it really comes down to needing a solution sooner rather than later."
There are some doubts. The exchange would need the support of the main dealers. "If the majority of the liquidity providers refuse to participate, I highly doubt that this CME.L solution can get off the ground," said Robert McWilliam, vice president of derivatives trading at Maryland-based T. Rowe Price, which traded $1.2 billion in the CDS market last year.
"Unfortunately the relationship between the CME and the broker-dealers is rather toxic," he said.
McWilliam points to the near monopoly CME has gained in the U.S. futures, options on futures, and interest rates for the source of the friction.
But Miles Davis, head of capital markets at SMART UK, an advisory firm focused on the country's financial services sector, said the decision will boil down to who can handle the sheer volume of CDS. "CME has a clear lead there," he said.
Credit Suisse analysts estimate CDS trading could generate fees for the exchanges of $400 million a year in the near term - small in comparison to the CME's $1 billion in revenues from the interest rate market on the back of a notional amount outstanding of $37.4 trillion a year.
But in the longer term, as CDS volumes rise in a better regulated market, annual revenues could jump to $2.5 billion over the next five years following a shift to centralized clearing, the analysts said.
That may explain why exchanges have lobbied so hard to curry favour with regulators and legislators.
All four of the potential counterparties, as well as dealers and buyside firms, met to discuss the CDS market with U.S. regulators and the European Central Bank at the Federal Reserve Bank of New York last week without agreeing anything concrete.
But analysts say the big banks would be wise to unanimously endorse the TCC platform and set a firm launch date, which for now is pegged near the end of the year.
"Given that the government is going to choose on this one, that's your wild card," said Brad Hintz, banking and exchanges analyst at Sanford C. Bernstein in New York.
HUNGER FOR A SOLUTION
U.S. and European leaders are calling for quick decisions regarding the transparency and safety of CDS markets. Analysts and market participants agree a centrally-cleared, exchange-traded model is needed for this market, which trades contracts that insure debt against default.
While the wounded banks may not want to give up their lucrative OTC business, pressure to reduce risk and to expose less of the banks' balance sheets is expected to push them onto exchanges.
Past efforts by exchanges to offer a one-stop alternative to the vast OTC markets have flopped. But the biggest financial crisis in 80 years gives them the backing of regulators in their quest to win market share.
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(Additional reporting by Jane Baird; Editing by Chris Wickham)