June 10 (Bloomberg) -- Regulators and banks agreed to changes aimed at easing the risk of a collapse in the $62 trillion market for credit-default swaps.

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. are among the 17 banks creating a system to move trades through a clearinghouse that would absorb a failure by one of the market-makers, the Federal Reserve Bank of New York said yesterday in a statement following a meeting with the firms.

This will reduce ``the systemic risk when a large counterparty fails,'' Tim Brunne, a Munich-based credit strategist at UniCredit SpA, said in an interview today. ``A large portion of the market would be trading against the central counterparty, and that would be a good thing.''

Investor concern that the market may fail was fueled in March when Bear Stearns Cos., then the fifth-biggest U.S. securities firm, faced a cash squeeze. The central bank agreed to back an emergency sale of Bear to JPMorgan Chase & Co. in part because of the systemic losses that would have resulted if the firm had filed for bankruptcy, New York Fed President Timothy Geithner said in a speech to the Economic Club of New York yesterday.

A central counterparty, more automated trading and settlement and other fixes ``will help improve the system's ability to manage the consequence of failure by a major institution, and we expect to make meaningful progress over the next six months,'' Geithner said.

Repay Debt

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value should the company fail to adhere to its debt agreements.

The Fed has conferred with banks since September 2005 to improve processing and settlement in the market, initially to clean up a backlog of unconfirmed trades as dealers fell behind the pace of market growth.

The 17 banks at the meeting yesterday handle about 90 percent of the trading in credit-default swaps, Geithner said. Ten of the banks are owners of Clearing Corp., which has said it will start guaranteeing credit-default swap trades by September.

The Chicago-based company will start with the most actively traded contracts, the benchmark CDX indexes, according to a statement last month. Later, it will start clearing European indexes and contracts linked to individual companies.

Only market participants meeting ``requirements relating to creditworthiness and experience'' trading in the market will be allowed to clear trades through the company, the bank-owned clearinghouse said in the statement.

`Incremental Baby Steps'

While the efforts will help, the Fed, the U.S. Securities and Exchange Commission and Congress should be moving faster to bring the entire market under a central counterparty, said Christopher Whalen, co-founder of financial consulting firm Institutional Risk Analytics in Torrance, California.

``These proposals are fine, but they're still incremental baby steps along a path that we shouldn't be thinking about anymore,'' Whalen said in a telephone interview today. ``We should have the full force of God, with the Fed and the SEC and the chairmen of the various committees on the Hill in front of the cameras telling the industry to fix this right now.''

Outstanding contracts at the end of 2007 carried a gross market value of about $2 trillion, representing the cost of replacing all existing trades, according to the Bank for International Settlements in Basel, Switzerland.

`Operational Strain'

Should one of the market-makers collapse under the existing framework, it may trigger ``several hundred million dollars'' in losses for the banks and investors on the other side of trades with that firm, Moody's Investors Service analysts led by Alexander Yavorsky in Jersey City, New Jersey, wrote in a report last month.

The need for investors and banks to replace credit-default swap protection bought from that firm also would drive the cost of those contracts higher, creating more losses and putting the market ``under unprecedented operational strain,'' the Moody's analysts said.

Investment firms AllianceBernstein LP, Citadel Investment Group LLC and BlueMountain Capital Management LLC joined the Fed meetings yesterday for the first time.

In addition to a central clearing mechanism, the group agreed to include in standard trading documents a mechanism for settling trades with cash instead of having to physically deliver the underlying securities.

The efforts also will reduce the volume of outstanding contracts through multilateral trade terminations, the Fed said. And the group agreed to extend the changes in credit-default swaps to other derivatives contracts backed by equities, interest rates, currencies and commodities.

The banks will provide details on their next steps by July 31, the Fed said in its statement.

To contact the reporters for this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Oliver Biggadike in Tokyo at obiggadike@bloomberg.net

Last Updated: June 10, 2008 13:06 EDT