U.S. federal bankruptcy laws may need to change to protect hedge funds and other institutions trading credit default swaps, derivatives exchanges warned Monday in a report to the New York Federal Reserve.

In the 150-page document, IntercontinentalExchange Inc. (ICE) and CME Group Inc. (CME) said that legislative and regulatory action may be necessary to guard buy-side firms against potential failures of clearing member banks involved in exchange-backed facilities set up to handle credit derivatives trades.

With ICE's credit default swap clearinghouse up and running and a competing facility from CME approved for launch, regulators and market participants have pushed for broader protection of hedge funds, pension funds and other non-bank traders of credit default swaps, over-the-counter instruments that pay off in the event of a bankruptcy.

Credit derivatives figured into the downfall of insurer American International Group Inc. (AIG) last fall, and banks' bilateral positions in the often-complex instruments prompted calls from Washington to reduce counterparty risk in the market, currently estimated to be around $27 trillion.

Derivatives exchange operators like CME, ICE and Deutsche Boerse's (DB1.XE) derivatives arm Eurex have moved to develop clearing services for the swaps, structuring the facilities to incentivize the dealer banks that account for most of the activity in the market.

Executives of ICE and CME pledged that their clearinghouses would also protect buy-side participants in the event that a clearing member bank defaults, but details have remained hazy as exchanges focused on getting the facilities operational.

In the report to the New York Fed, CME proposed amending the U.S. bankruptcy code to help resolve persistent "uncertainties" around protecting buy-side firms.

The Chicago-based exchange operator said that market participants looking to clear credit default swap trades through a U.S. futures commission merchant may need to be covered by existing rules for commodity contracts in the event of an FCM bankruptcy.

ICE suggested its own amendments to statutes covering its clearing framework, requesting rules for the segregation of collateral posted for credit default swap trades, and asking that the Federal Depository Insurance Corp. transfer cleared credit derivatives positions separately from non-cleared positions in the event of a clearing member firm's failure.

Atlanta-based ICE also wants regulators to assist in the timely return of customer collateral in the event of a clearing member's bankruptcy, and to allow the clearinghouse to shift customers' credit default swap positions to other clearing members if need be.

ICE's credit derivatives clearinghouse, supported by major Wall Street banks, has processed more than $1.3 trillion in credit default swap trades since its launch in mid-March.

CME's rival platform, a joint venture with Chicago-based hedge fund firm Citadel Investment Group, has yet to open for business as the companies work to secure support from dealers.

-By Jacob Bunge, Dow Jones Newswires; (312) 750 4117; jacob.bunge@dowjones.com