Tuesday, May 19, 2009

Let battle commence

Posted in the Financial Times by Gilian Tett and Aline van Duyn:

Last Wednesday night, David Clark, a London-based banker, received a nasty shock. Reports from Washington suggested the US government would soon impose restrictive new regulation on the derivatives world – a move Mr Clark believes could severely damage financial business in London and New York.

He duly prepared a furious statement on behalf of the Wholesale Market Brokers’ Association, a lobbying group he leads. But when, a few hours later, he saw the proposals from Tim Geithner, US Treasury secretary, Mr Clark had second thoughts. “What Geithner has written may not be so bad,” he says, adding there is now “uncertainty” about what will happen next.

No wonder. Until recently, the technical detail of derivatives excited only financial geeks. Now it is turning into a political hot potato with potentially big implications for bank profits. After the first wave of policy reforms unleashed by the administration of Barack Obama in response to the financial crisis, focused on short-term crisis measures, such as the “ stress tests” of the health of banks, the next frontier is a fight about how the financial industry is structured – and run.

And what makes the once arcane issue so emotive is that they are not just central to the banks’ modern business model but also raise questions about the degree to which financial players should be free to innovate, without state control.

A public debate about derivatives is long overdue. For while politicians – and consumers – largely ignored this sector during the first seven years of the decade, an extraordinary revolution has quietly unfolded in recent years.

When the trading of “derivatives” – instruments whose value “derives” from something else – took off on a large scale three decades ago, it was a marginal corner of finance. By the start of this decade, the Basel-based Bank for International Settlements estimated there were about $100,000bn of outstanding deals. By late 2008 there were nearly $600,000bn, 16 times global equity market capitalisation (and 10 times global gross domestic product).

Bankers insist that these astonishing numbers are misleading, since many outstanding contracts offset each other in economic terms. Indeed, the BIS estimates that, after such netting, the “real” net market value of derivatives deals was “only” $34,000bn last year.

Nevertheless, the presence of those $600,000bn overlapping deals is important, since banks typically collect a fee on every (gross) contract written. Moreover, these deals have trapped banks and other financial players in a complex web of counterparty risk.

In the equity market, most trading occurs on a regulated exchange where deals can be publicly monitored by every­one. Trades are then “cleared” on a central platform, which completes a deal even if one counterparty collapses. Some derivatives deals – such as government bond futures – are traded on similar exchanges in Chicago and London. However, BIS data suggests four-fifths of outstanding derivatives trades have been cut in the so-called “over-the-counter” world, via private deals.

That means in many cases there is no centralised system to monitor prices or deals nor any third party to ensure a trade is completed if a counterparty fails. And while the industry has tried to mitigate this “counterparty risk” by encouraging traders to post collateral when they cut deals, these arrangements are not always seen as robust.

When Lehman Brothers collapsed last autumn, for example, markets froze because investors were unsure whether their deals would be completed. Worse, because trades were private, neither regulators nor investors knew where the risks lay. As a result, the US government was convinced the insurance group AIG – which had credit derivatives deals with dozens of other banks – could not be allowed to collapse.

As Mary Schapiro, chair of the Securities and Exchange Commission, says: “OTC derivatives, particularly credit derivatives ... contributed to the financial mess we are cleaning up today.”

The proposals Mr Geithner, Ms Schapiro and others have unveiled try to tackle these problems in four ways. First, they demand all “standardised” derivatives are centrally cleared to remove counterparty risk, even if they are not traded on an exchange.

Second, they “encourage” the industry to use regulated exchanges in addition to clearing platforms (because it is only on exchanges that investors get equal access to trading and price data, rather than being forced to rely on a small club of dominant banks).

Third, the Obama administration wants all institutions to record every derivatives trade to enable supervisors to prevent market abuse. Fourth, it wants to tighten rules on capital and collateral provision to ensure all derivatives players have buffers to absorb any losses. That is a radical step because, while banks already face such rules, hedge funds, companies and insurance groups such as AIG do not.

More striking still, the administration wants to impose a sliding scale of capital charges to “steer” behaviour. Derivatives deals conducted on regulated exchanges will attract lower charges than OTC deals.

To some, the measures look timid. Christopher Whalen, a US financial analyst says the way to remove systemic risk is to force all trades on to transparent exchanges. Banks, he says, will fight this as OTC activity is a dominant source of profits for some. Deals cut on exchanges typically produce a few basis points of commission but OTC trades can produce revenue of several percentage points.

“Despite the appearance of reform, the Treasury proposal ... still leaves the OTC market firmly in the hands of the large derivatives-dealer banks,” says Mr Whalen. “Without the excessive rents earned by JPMorgan Chase and the remaining legacy OTC dealers, the largest banks cannot survive.”

Frank Partnoy, a former derivatives trader, now an academic, thinks the proposals fall short because they cover only “standardised” deals – not the complex contracts that wreaked havoc at AIG and elsewhere. “By bifurcating the market into some derivatives that are standardised and disclosed, and some that are not, there is a [loop] hole that can only get bigger,” he says.

Although the administration has not defined “standardised”, a narrow definition may capture less than half of all recent deals. In credit derivatives most index trades and deals on single company bonds can be considered standardised by some measures. Bundles of derivatives, such as collateralised debt obligations, cannot.

The banking industry, by contrast, complains the reforms go too far. Most senior financiers are willing to move some activity on to a clearing platform. Indeed, this shift was under way before last week’s announcement – ventures offering clearing functions for credit derivatives started operating this year. Some large brokers, such as Icap, also accept the idea of limited exchange trading – not least because Icap runs an electronic exchange.

However, bankers oppose the idea that all activity should be channelled to an exchange, claiming it would crush innovation and reduce liquidity, because banks would no longer have a profit incentive to cut deals.

“Forcing OTC products on to exchanges ... would result in increased risks and costs for end users,” says Mr Clark of the WMBA, which says British pension funds have saved themselves £40bn recently by hedging with derivatives. Or as Anthony Belchambers, head of the Futures and Options Association, says: “This kind of regulatory pressure will distort free-market competition and restrict product diversity.”

In reality, it is unclear how far the administration plans to drive activity on to exchanges. Washington is still trying to steer a careful line between populist politicians who can sense public anger and the powerful financial lobby. Senior US officials hope a sliding scale of charges will be less controversial than a ban. After all, they point out, market-based “incentives” sit more easily with US free-market ideals than government diktat.

But nobody in Washington expects the debate to be won fast. And what makes Mr Geithner’s plan doubly controversial is that its implications go way beyond Washington itself.

When he met reporters last week Mr Geithner paid lip service to the “very important process” of global co-ordination. However, Washington appears to have engaged in scant consultation with Europe before last week’s announcement. The European Commission is now preparing measures to impose centralised clearing on credit derivatives, which it may extend to OTC derivatives. US finance officials assume European measures will ape US moves but this is not guaranteed.

In the meantime, bankers in London are preparing to exploit any transatlantic regulatory gaps. “Only 25 per cent of all OTC trading actually happens in America,” one senior London-based banker says. “So we don’t think what Geithner says is going to change anything for us ... and even if [Brussels] does the same, activity will just go to Singapore or Switzerland instead.”

Sentiments like that explain why US politicians distrust the derivatives world. They also illustrate the nightmarish difficulty reformers face. After all, several times in the past three decades, US politicians have tried to clamp down on derivatives – and each time the Wall Street lobby has fought back.

Some observers, such as Willa Bruckner, a partner at Alston & Bird law firm and veteran of earlier battles, hope this time will be different. In the past the industry convinced regulators it was able to regulate itself. “But because of the magnitude and the breadth of this crisis, these arguments are not so convincing now,” she says.

Not everybody agrees Mr Geithner truly has the stomach for change. The one thing that is crystal clear is that “the [banking] industry is girding for battle, [hiring] armies of lobbyists and lawyers,” as Mr Whalen says. Stand by for a long – and potentially bitter – derivatives war.


Written off by many when the alternative trading platforms arrived, big exchanges now find they are again places of value

“Thank you Tim Geithner and friends” was the gushing endorsement from one exchanges analyst when the US Treasury secretary unveiled plans for sweeping changes to the over-the-counter derivatives markets last week, writes Jeremy Grant.

For years, a tug-of-war has raged between the big derivatives exchanges, from their home turf in Chicago, and the OTC markets, represented by dealers at the Wall Street banks. The inventors of financial futures in the Windy City in the 1970s were appalled at the emergence a decade later of products developed by the banks that looked suspiciously like copies of their own inventions. They wanted all derivatives traded on-exchange.

The two sides reached a deal in 2000 with the Commodity Futures Modernisation Act. The exchanges agreed not to oppose an exemption of the OTC markets from oversight by the US futures regulator, while the OTC players would not oppose a “light touch” regulatory regime that the exchanges had been seeking for their part of the markets. But rivalry persisted, especially as OTC derivatives overtook the size of exchange-traded markets at the Chicago Mercantile Exchange, now CME Group.

Fast forward to the collapse of Lehman Brothers last September. Things started to go the exchanges’ way when Mr Geithner – then chairman of the Federal Reserve Bank of New York – insisted that OTC contracts should be processed as far as possible through a clearing house, to safeguard the financial system against the fallout from another catastrophic default.

Now, with a stipulation by the administration of President Barack Obama not only that OTC derivatives should be cleared but also that “standardised” OTC derivatives should be moved on to exchanges, the exchanges appear to have won a victory in that battle – hence the ringing endorsement from the analyst, who covers CME.

A sense that the exchanges have been unexpected beneficiaries from the financial crisis has been heightened elsewhere. A mere 18 months ago in Europe, analysts were predicting that competition unleashed by the European Union’s Markets in Financial Instruments Directive would leave exchanges badly damaged by upstart trading platforms such as Chi-X and Turquoise. Yet this week, as the London Stock Exchange introduces Xavier Rolet, a former Lehman banker, as its chief executive, the rivals have yet to hole the exchange below the water line.

None of the five platforms in existence is making money, even as they collectively claim more than 20 per cent of trading in the shares of companies that make up the FTSE 100 index. In addition, the LSE says many users of the OTC equity markets have started shifting orders on to the exchange, where trades are cleared through LCH.Clearnet.

However, it is too soon to write off important players in the OTC markets. Susan Milligan of The Options Clearing Corporation, which clears for all seven US options exchanges, says the exchange-traded and OTC derivatives markets have long had a symbiotic relationship as traders use them to arbitrage one against the other. That means one market’s gain is not necessarily the other’s loss, making it hard to conclude that a regulatory push to shift contracts on to more formal structures is wholly damaging to the OTC markets. “There has been a long-standing push and pull between the [OTC] dealers and the exchanges but if you look at the CME’s volumes, one of the reasons that’s down is there aren’t as many OTC contracts being traded,” she says.

The inter-dealer brokerages that act as intermediaries in the OTC derivatives markets, negotiating contracts on the phone or electronically on screens, will find their phone broking businesses hurt by the new regulatory environment. But those with large electronic businesses – Icap, Tullett Prebon, GFI Group and BGC Partners with its eSpeed platform – could benefit. The US administration wants “standardised” OTC contracts to be traded not only on “regulated exchanges” but on “regulated transparent electronic trade execution systems”. That could be taken to mean the brokers’ systems, although the detail will have to be thrashed out in Congress.

Icap has not wasted time in developing post-trade services for OTC markets – making it more “exchange-like”. It has also joined a 12-member bank consortium that is bidding for LCH.Clearnet, a move that would give the broker an interest in an operation that already clears swaths of the interest rate swaps markets.

Michael Spencer, Icap’s chief executive, says: “All the arrows have pointed in this direction for some time. We had anticipated that there would be a push to clear certain [OTC] products.”

Yet the non-exchange side cannot rest easy as long as the regulatory pressure to make markets “safer” persists. The big fear among inter-dealer brokers is of a blind rush to push everything on-exchange even though non-exchange venues could fulfil the Geithner requirements – such as more clearing through LCH.Clearnet, which is not exchange-owned.

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