Credit crisis an opportunity for Atlanta-based ICE

Until recently, few people had even heard of a credit-default swap.

But the highly complex type of security — essentially lenders’ insurance against bad loans — is widely blamed for helping fuel the financial crisis sweeping Wall Street.

Now, Atlanta-based IntercontinentalExchange, or ICE, could be in position to help federal regulators sort through the wreckage and create a less-risky marketplace for trading the securities.

ICE, a fast-growing company that operates commodities futures markets around the globe, is one of several financial firms scheduled to meet with Federal Reserve Bank of New York officials Tuesday, according to people familiar with the meeting. They’ll discuss the New York Fed’s previously announced plan to create an open, central market for credit-default swaps that could be run by a private company or group of firms.

Though it is unclear whether the upstart company has a strong shot, the prospect was significant because it involves a business opportunity in a multi-trillion-dollar market. That ICE might play a key role in repairing a financial mess was notable, given that some critics partly blamed ICE for allowing speculators to run up the price of oil last spring.

ICE declined to comment, but the company could be well-suited to the task of helping build a market for swaps. It has experience running trading exchanges and recently bought Creditex, a leading credit-default swaps brokerage firm.

ICE is likely to have competition for any new business. One of ICE’s main rivals, the Chicago Mercantile Exchange, has said it is ready to start an exchange for the swaps. The mercantile exchange declined to comment.

Michael A. Goldstein, an associate professor of finance at Babson College in Wellesley, Mass., said the Chicago exchange appears to have a leg up because it has a longer working relationship with federal regulators than upstart ICE.

“This seems pretty important, and if I were the regulators that’s where I’d put it,” said Goldstein, who specializes in capital markets, security exchanges and trading systems.

But whichever company is picked to run the new exchange, Goldstein said, it must offer what thus far has been lacking in the market for credit-default swaps: transparency — that is, clear, accessible information. A new market must be designed to allow monitoring, but not impede trading, he said.

“It will have to be highly regulated, but not so regulated that it would destroy the market,” he said.

The credit-default swap is a relatively new financial product that has grown exponentially in recent years. Banks and other investors bought them in huge quantities to guard against risky securities tied to subprime mortgages.

The market for credit-default swaps is now estimated to be a staggering $54 trillion — about four times the nation’s entire gross domestic product.

The swaps seemed to make sense: if loans backed by a swap go bad, the swap issuer would cover any losses.

But because the credit-default swap market is unregulated, financial firms that issue the swaps haven’t been required to have capital in reserve to offset potential losses should swap holders need to cash them in.

That wasn’t a problem when real estate was booming. But when the subprime mortgage market collapsed, a number of companies were suddenly on the hook for billions of dollars worth of swaps. That’s what contributed to the collapse of AIG, the insurance giant.

ICE has risen from obscurity in recent years to challenge some of the most venerable financial institutions, such as the Chicago Mercantile Exchange, which outbid ICE for the Chicago Board of Trade last year.

ICE has 535 employees and made a profit of $240 million last year, compared to $22 million in 2004. It primarily serves as an electronic exchange for futures on commodities such as oil, sugar and cotton.

The company’s involvement in the credit-default swaps talks comes only a few months since critics charged that it had let one of its markets become a tool for speculators.

Traders on ICE’s oil futures exchange dramatically bid up its price to nearly $150 a barrel — almost tripling its price in a year-and-a-half. Now, oil is back below $90 a barrel.

Studies of that run-up have conflicted, with at least one concluding that ICE’s markets had been exploited by several speculators to artificially induce soaring prices, then make huge profits. ICE officials vehemently denied that their markets were manipulated, and at least one study backed them up.

Global oil markets, compared to credit default swaps, are more easily tracked and assessed. In comparison, credit swaps are more esoteric than oil, and will require more monitoring, said Goldstein, the Babson professor.

Credit default swaps were toxic partly because they were traded and re-traded past the point of knowing who the original sellers were. There was no way to judge their value, Goldstein said.

That uncertainty meant that each failure tainted others, he said. “It is like a tangled web.”

In contrast, a futures market uses the exchange itself as a kind of “middleman” for each transaction, he said. That means that the buyer and seller are identified, and, if there is a problem, the fallout is limited.

Moreover, the value of the credit default swaps will be “marked to market,” that is, revalued each day to reflect the demand for them.

“So if there is a problem, all you’d lose is one day’s change,” Goldstein said. “The bankruptcy risk would be reduced dramatically. Had we done this a year ago, maybe things would not have been so bad.”