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Section: Daily Dispatches

... but now other derivatives have
gotten so out of control that the
Fed itself is intervening.

* * *

Fed, Banks Will Meet Over Derivatives

By Henny Sender, Michael Mackenzie,
and Ramez Mikdashi
The Wall Street Journal
Thursday, August 25, 2005

The Federal Reserve Bank of New York will meet with Wall Street
banks next month to discuss the still relatively opaque market for
credit derivatives.

The market is a young but rapidly growing one where traders and
investors use the derivatives to buy and sell protection against
defaults. Trading volumes have soared, but back-office functions
needed to make sure trades get completed haven't kept up with that

It is these so-called settlement issues that the New York Fed wants
to discuss with the bankers on Sept. 15. New York Fed President
Timothy Geithner sent a letter to dealers on Aug. 12 inviting them
to meet on "how best to address a range of important issues in the
credit-derivatives market."

While those issues appear technical, they are essential to keep
losses from snowballing into more systemic problems when the markets
are volatile.

In May, for example, a downgrade of General Motors Corp. debt
sparked violent moves in the market for credit derivatives and at
least paper losses for Wall Street firms and the hedge funds on the
other side of some trades. Those events led to calls for greater
discipline and monitoring. More recently, problems surfaced when car-
parts company Collins & Aikman Corp. filed for bankruptcy
protection. A daisy chain of trades made it hard for many in the
market to figure out who their ultimate counterparty was.

According to the International Swaps and Derivatives Association,
the notional value of credit-default swaps outstanding reached $8.4
trillion at the end of 2004, a ninefold increase in just three years.

The New York Fed invited 14 banks from the U.S. and abroad but
declined to name them. The credit-derivatives market is dominated by
a handful of banks, including J.P. Morgan Chase, Deutsche Bank AG,
Morgan Stanley, Goldman Sachs Group, and Citigroup. Goldman Sachs
and J.P. Morgan declined to comment, while other banks couldn't be
reached for comment.

Hedge funds account for much of the recent surge in credit-
derivatives activity. Banks welcome the funds as trading partners,
but the funds sometimes move out of trades -- "assign" them --
without telling the bank that sold them the credit-derivative
contract. This makes it harder for other participants to know
whether their positions are properly hedged.

Questions about the rising backlog of trades that haven't been
settled have been with the market for some time. Indeed, the issues
the Fed raises in its letter have been flagged by regulators in the
United Kingdom and most recently in a report last month from the
Counterparty Risk Management Group led by Gerald Corrigan, a former
New York Fed president.

Federal Reserve Chairman Alan Greenspan and others have praised the
role of the derivatives market in diluting financial risk, although
the central-bank chief did warn in a speech in May of the potential
risks to the economy if the use of derivatives isn't properly

Banks and even some hedge funds say they welcome the Fed's
initiative because it will help them focus on how to beef up their
own back-office functions.

"We've always thought issues surrounding confirmations, settlements
and assignments were really important, and have ourselves invested a
great deal of time, money, people and technology to make sure that
we've got this right," said Stephen Siderow, president of
BlueMountain Capital Management, a hedge-fund manager overseeing
investments of $2.7 billion. "We think these kinds of conversations
between dealers and regulators can be very valuable."


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