Wednesday, March 24, 2010

Derivatives doubt likely to hit bank revenues

Posted in the Financial Times by Aline van Duyn and Michael Mackenzie:

The future shape of the derivatives markets, one of the big sources of revenue and profits for Wall Street banks, is still incredibly hard to map out.

In the US, Republicans and Democrats last week failed in their efforts to reach agreement on rules requiring most privately traded, or over-the-counter, derivatives to pass through a central clearing house. As a result, there are unanswered questions about the final shape – and timing – of this legislation.

“[Bi-partisan] talks on derivatives reform have collapsed, which we believe significantly diminishes the prospects for OTC derivatives reform becoming law this year,” say analysts at Keefe, Bruyette & Woods.

Even if new laws remain elusive, moves to bring many of the privately negotiated contracts for credit default swaps, interest rate swaps and other derivatives into clearing houses have started to take place anyway. In theory, this should reduce the risks of systemic collapse to the global financial system if a derivatives dealer goes bust, as the clearing house takes on the risks of such a default.

Yet even as clearing is embraced – including by many of the big derivatives dealers such as Bank of America, Barclays Capital, Deutsche Bank, Goldman Sachs, JP Morgan and Morgan Stanley – there remain a lot of profits to fight for.

In a recent report about the banking industry, Morgan Stanley and consultants Oliver Wyman estimated that 2010 revenues for large banks from the credit and securitisation businesses are projected to decline by 40 per cent from 2009 levels to $33bn. One key reason for this drop are the regulatory threats to securitisation and credit derivatives, both in terms of calls for increased capital and clearing. What happens after this year is uncertain.

“We expect the OTC flow markets to be dramatically reshaped,” the report says. “In our base case, we assume the sell-side margin erosion is largely offset by increased volumes, imp­roved cost structure and balance sheet efficiency. However, the bear case scenario of regulatory enforced exchange trading or severe loss of liquidity via badly thought through central counterparty solutions remains a distinct possibility.”

What complicates the debate in terms of future profits from derivatives – and costs for users – is the double uncertainty about the impact on markets of clearing and potential price reporting rules and exchange trading requirements, and rules from global regulators such as the Basel Committee about the amount of capital banks should have to hold for derivatives trades and positions.

Tabb Group estimates that there is $40bn in annual revenues in global OTC derivatives, excluding credit derivatives, in play for the top 20 dealers.

Regulators are expected to require less capital for cleared derivatives – a business that is only being done by a handful of clearing houses – because of the risks that uncleared markets pose to the safety of the financial system.

A key issue is how much more is required for uncleared derivatives, and whether or not such capital rules will take into account positions that in theory offset each other.

Indeed, even if banks or other big users of derivatives such as some non-financial companies are able to avoid centralised clearing or the reporting of prices at which deri­vatives trade, they may still face higher costs for using derivatives through capital charges.

However, there may be a shift in timing.

“The train has left the station on clearing more OTC derivatives and this legislative stalemate gives dealers more time to take control of their own destiny and move towards clearing in their own time,” say the Keefe, Bruyette and Woods analysts. “It also gives the US regulators some breathing space for the international regulators to get on board.”

While much attention is focused on credit derivatives, this sector is dwarfed by the interest rate sector. These are now particularly in focus after the regulator of mortgage agencies Fannie Mae and Freddie Mac announced this month that the two lenders would press ahead with using clearing houses for their swaps portfolios this year – whether or not legislation was passed.

Interest rate derivatives account for more than 70 per cent of the global OTC market at a notional value of $437,000bn, with interest rate swaps clocking in at $342,000bn in notional exposure, according to the Bank of International Settlements.

About 25 per cent of that market is pushed through central clearing, a figure that could rise to 65 per cent by 2012, says Tabb Group.

“For many years, much-needed modernisation has been put on hold and the status quo has been preserved,” says Paul Rowady, senior analyst at Tabb Group. “The remaining challenge is how to inspire, convince or otherwise incentivise major dealers to move to more automated execution.”

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