Saturday, October 17, 2009

OTC Trading Amendment Won’t Cut Risk, May Cost Banks Billions

Posted on Bloomberg by Shannon D. Harrington and Matthew Leising:

A U.S. House committee’s proposal to change how private derivatives are bought and sold won’t make the financial system more stable and may shift profits to exchanges from banks, analysts and a former regulator said.

“Exchange trading doesn’t reduce systemic risk,” said Alexander Yavorsky, a senior analyst at Moody’s Investors Service in New York.

Rep. Barney Frank, chairman of the House Financial Services Committee, reversed course with an amendment in a bill passed yesterday by the panel that may move much of the trading in the $592 trillion over-the-counter market to exchanges or regulated systems. His draft had allowed for no change in how the derivatives are traded, as long as transactions are reported to regulators.

Risk is reduced through clearinghouses and reporting transactions, not by trading on exchanges, said Richard Lindsey, a former director of market regulation at the Securities and Exchange Commission. The main effects of the proposal may be to slash profits at banks, including Goldman Sachs Group Inc. and JPMorgan Chase & Co., while boosting revenue at exchanges such as CME Group Inc. and Intercontinental Exchange Inc.

“We’re in a new situation; we’re going to be driving a lot of business to the exchanges,” Frank, a Massachusetts Democrat, said during debate on the provision, which he said may lead to more competition and help create more independent exchanges.

$35 Billion

The top five U.S. commercial banks, including JPMorgan, Goldman Sachs and Bank of America Corp., were on track through the second quarter to earn more than $35 billion this year trading unregulated derivative contracts, according to a review of company filings with the Federal Reserve and people familiar with the banks’ income sources.

Derivatives contributed to more than $1.6 trillion in writedowns and losses at the world’s biggest banks, brokers and insurers since the start of 2007, according to data compiled by Bloomberg. After American International Group Inc. was forced to come up with $18.5 billion in collateral to cover $62 billion in credit-default swaps trades, the government was forced to rescue the insurer with a bailout that expanded to $182.3 billion.

Trading of private derivatives is now largely performed over the phone between banks, hedge funds, companies and other investors. Regulators who say they want exchange trading to boost transparency in the market have other means, said Lindsey, who now advises hedge funds and institutional investors at New York-based Calcott Group LLC.

‘Lucrative Market’

“The transaction reporting is really what gives you transparency, not simply trading on an exchange,” he said. The push for exchange trading “is mostly about the exchanges trying to capture what they view as a lucrative market.”

Market owners Intercontinental Exchange, CME Group, LCH.Clearnet Ltd. and Eurex have all offered plans in which their clearinghouses guarantee swaps. The firms are only backing the trades through their clearinghouses and haven’t executed any transactions on their exchanges.

Banks benefit when clients don’t know the value of transactions they buy. The worst scenario for their profits would be for the trades to be bought and sold on exchanges, said Richard Repetto, an analyst with Sandler O’Neill & Partners LP in New York.

“The big spreads they made are going to go away because the more transparent pricing makes spreads narrow,” he said. Dealers “will still make some money but nowhere near what they did before.”

JPMorgan spokesman Justin Perras and Goldman Sachs spokesman Michael DuVally declined to comment. CME Group spokesman Allan Schoenberg and Intercontinental Exchange spokeswoman Sarah Stashak declined to comment.

Swap Execution Facilities

The bill also gives the option of trading on so-called swap execution facilities, systems that would have to register with the CFTC or SEC and meet reporting and monitoring criteria.

Potential beneficiaries of the swap execution facility designation include TradeWeb, a bond and derivative trading network owned by Thomson Reuters Corp. and 10 dealers; MarketAxess Holdings Inc., an electronic trading system for U.S. and European fixed-income securities; and Blackbird Holdings Inc., an electronic trading system for derivatives. Interdealer brokers ICAP Plc and GFI Group Inc. could also see an increase in business on their electronic platforms.

TradeWeb and Thomson Reuters compete against Bloomberg LP, the parent of Bloomberg News, in providing financial information and trading.

Exchange Fees

“There’s no question that the multilateral clearing aspect of what’s being discussed is far more important than the price discovery aspect,” said Thomas Kloet, chief executive officer of TMX Group Inc., owner of the Toronto Stock Exchange and Canada’s derivatives market.

A swap execution facility could protect some dealer profit by being less transparent than an exchange. No rules have been spelled out for how much public disclosure would be required for that type of trading. An amendment to Frank’s bill specified that transactions done via telephone -- the way market participants have traded for decades -- qualified as a means of executing trades on the regulated platforms.

“Exchange trading, one could argue, is not a good thing for major banks because you’re having to pay exchange fees to exchanges” rather than profiting from putting the trades together, Yavorsky said. “Creating more transparency is going to lead to tighter spreads.”

Industry Group Opposition

The battle over how the contracts are bought and sold underscores a split in how banks and the government want to emphasize transparency at different parts of the transactions for credit-default swaps, interest-rate swaps and other contracts in the OTC market.

“ISDA and its members believe that mandatory exchange trading should not be required in any circumstance,” Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, told the House Agriculture Committee Sept. 17. “Mandating that OTC derivatives contracts trade on an exchange would undercut their very purpose, the ability to custom-tailor risk management solutions to meet the need of end- users.”

New York-based ISDA sets standards in the market and represents more than 800 firms.

The Treasury, Commodity Futures Trading Commission and SEC have pressed Congress to tighten trading requirements.

“We don’t want to allow any firm like an AIG to be able to engage in derivatives transactions without requiring those transactions to be reported and to be traded on an exchange or an alternative execution facility,” Assistant Treasury Secretary Michael Barr said on a conference call with reporters this week.

Efficient for Regulators

Moving trades to exchanges or swap execution facilities is the most efficient way for regulators to keep an eye on the market and to create a level playing field for all participants, according to CFTC Chairman Gary Gensler.

Derivatives are contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather. Credit-default swaps, one type of privately traded derivative, were used to replicate pools of mortgages that banks created to sell to investors, in what was known as a synthetic collateralized debt obligation. Losses from synthetic and other types on CDOs have totaled more than $118 billion since the third quarter 2007, according to Bloomberg data.

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