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Fed Turns Focus to Derivatives Market,
Wants Improved Infrastructure Soon

Federal regulators are zeroing in on the vast but lightly regulated credit-default-swap market in their efforts to repair the financial system as the credit crisis unfolds.

On Monday afternoon, the Fed summoned senior executives of 17 dealers to a two-hour meeting to discuss ways to quickly address weaknesses in the infrastructure of the derivatives market. The attendees, which included Wall Street banks such as Morgan Stanley and J.P. Morgan Chase, and also hedge funds such as Citadel Investment Group and BlueMountain Capital Management, are parties to more than 90% of credit-derivatives trades that take place directly between individual firms.

It was the first time hedge funds were part of the Fed's meetings on credit derivatives, underscoring the growing influence of hedge funds in this corner of the market.

Alarm about swaps was heightened by Bear Stearns' troubles in March. Regulators were concerned about the mountain of swaps to which it was a party and how its demise might impact the broader market. Bear had around 750,000 derivatives contracts outstanding, according to the New York Fed.

"These changes to the infrastructure will help improve the system's ability to manage the consequences of failure by a major institution," said Timothy Geithner, president of the New York Fed, in a speech at the Economic Club of New York. He added that he expected results within six months.

It's not the first time the Fed has summoned Wall Street firms to clean up their act in this market. In 2005, Mr. Geithner prodded investment banks to do a better job of documenting their trades.

Swaps contracts have been written on over $62 trillion worth of bonds and loans. These contracts are like insurance policies: one firm agrees to compensate another firm if a bond defaults, in exchange for regular payments.

Even before Monday's meeting, Wall Street firms and other market participants were working to establish a central clearinghouse that will stand between banks and brokers in swap trades and help cushion the impact of a collapse by any single firm.

A Chicago-based firm called The Clearing Corp. is gearing up to start clearing some credit-default swap trades this fall, starting with contracts that have more standardized terms.

Reuters
New York Federal Reserve President Timothy Geithner at a news conference earlier this year.

Regulators also are prodding banks and brokers to standardize more of their trades and reduce the amount of outstanding derivative contracts by "netting" them with their counterparties. Market players are trying to improve the way these contracts are settled when a specific bond or loan actually defaults.

The Fed is zeroing in on another market -- the "secured funding," or repo, market, where dealers obtain short-term, often overnight, cash loans by selling securities and agreeing to buy them back the next day from lenders that include money-market funds and others. One corner of this market, called the "tri-party repo" market, has expanded rapidly in the past couple of years and is now viewed by regulators as a potential source of systemic risk.

In this market, big banks draw on around $2.5 trillion daily to fund their positions. The quality of securities pledged to back this borrowing varies beyond easily tradable Treasury bonds and agency mortgage securities to less-liquid securities. Regulators worry about a sudden evaporation of funds in this market, as also happened in March.

Write to Serena Ng at serena.ng@wsj.com⁶ and Emily Barrett at emily.barrett@dowjones.com⁷

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