Monday, December 28, 2009

How Overhauling Derivatives Died

Original posted in the New York Times by Randall Smith and Sarah N. Lynch:

Lobbying by Wall Street has blunted efforts to step up regulation on derivatives trading by carving out exceptions or leaving the status quo in place.

Derivatives took blame for some of the worst debacles of the financial crisis. But a year after regulators and critics began calling for an overhaul in the way they are traded, some efforts have been shelved and others have been watered down.

The two main issues concerning regulators were trading and clearing of swaps, which allow investors to bet on or hedge movements in currencies, interest rates and many other things. Swaps generally trade privately, leaving competitors and regulators in the dark about the scope of their risks. In November 2008, the chairman of the Senate Agriculture Committee proposed forcing all derivatives trading onto exchanges, where their prices could be publicly disclosed and margin requirements imposed to insure that participants could make good on their market bets.

But a financial-overhaul bill passed by the House of Representatives on Dec. 11 watered down or eliminated these requirements. The measure still allows for voice brokering and allows dealers to use alternatives to public exchanges.

A lawyer for one big Wall Street dealer said in an interview that the rollback from the first proposals in Congress was the result of an "educational" process by dealers and customers that resulted in "a grudging recognition" that many uses of derivatives didn't fit such a strict approach. At one point, House agriculture chairman Collin Peterson (D., Minn.) said he suspected dealers had dispatched their customers to lobby Capital Hill.

For Wall Street, switching to exchanges would have cut their profits in a lucrative business. "Exchanges are anathema to the dealers," because the resulting added price disclosure "would lower the profits on each trade they handle, and they would handle many fewer trades," said Darrell Duffie, a finance professor at Stanford business school.

Clearing is considered important by regulators because it requires parties to a trade to post margin or collateral meant to ensure that each side can absorb losses if the trade moves against them. With derivatives, often little margin was required, allowing risks to pile up. Another issue that emerged with the failure of Lehman Brothers was whether such margin should be held in central clearinghouses. Exchange trading usually involves clearing with margin.

Dealers persuaded lawmakers to make exemptions to the clearing rules for some customers, including those covering foreign-exchange contracts, hedging by "end users" such as energy firms and airlines, and activities to offset "balance sheet risk," said Adam White, derivatives analyst at White Knight Research & Trading in Atlanta.

Mr. White says the Dec. 11 financial-reform bill will exempt nearly half of the $600 trillion in outstanding derivatives transactions from clearing requirements. Ohio Democrat Dennis Kucinich said in a statement he voted against the bill because it "contains a number of loopholes that sophisticated industry insiders will exploit with ease."

In an interview, House Financial Services Committee Chairman Barney Frank, who led efforts to craft the bill, defended the legislation, saying it is tougher than critics say. He said its clearing and trading provisions would require greater disclosure of trades and resulting risks, and give regulators more power to monitor and manage such risks.

The Massachusetts Democrat disputed Mr. Kucinich's implication that Wall Street dealers will be able to exploit the bill's exceptions, but said House Republicans had blocked some of his own efforts to make the bill tougher.

Wall Street executives say requiring end users to post additional margin could boost costs. An executive from Chicago utility Exelon Corp. told the Senate in September that requiring it to execute its electricity hedges on exchanges could require billions in additional cash outlays for margin that could boost prices to consumers. 3M Co. and Boeing Co. also warned of costs.

The Obama regulatory reform plan unveiled in June envisioned imposing higher capital requirements on dealers for customized, nonstandard derivatives that aren't cleared—to encourage dealers to send more to clearinghouses. But the House bill said only that capital and margin standards for off-exchange trades should be appropriate "for the risk associated with the noncleared swap," leaving specifics to regulators.

Some credit-default swaps clearing has already begun this year at the IntercontinentalExchange Inc., known as ICE, and CME Group Inc. The biggest derivative clearing operation, LCH Clearnet Group Inc. in London, already clears about one-third of roughly $200 trillion in interdealer interest-rate swaps.

A report Dec. 17 by Morgan Stanley analysts estimated that the volume of derivatives cleared could increase from a current 20% of the total to as much as 60% by 2012—a backdoor confirmation of critics' charge that 40% of the universe won't be covered.

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