Friday, March 12, 2010

Derivatives transparency is key battleground

Original posted in the Financial Times by Aline van Duyn:

First used more than 100 years ago, stock ticker tapes remain a common feature of the markets, even though the telegraph machines on which they originated have become obsolete.

Streams of stock abbreviations followed by the prices at which those shares have traded are a common sight across television screens and billboards.Now, the “tape” debate has hit a distinctly modern part of the markets – over-the-counter derivatives.

Indeed, one of the key battlegrounds in the derivatives industry is whether or not the prices at which many of the $600,000bn worth of derivatives contracts are traded, from credit default swaps to interest rate swaps, are made public.

On the one hand, regulators across the globe – and many politicians – are pushing for such disclosure, dubbed “post-trade transparency”. On the other hand, derivatives dealers are worried such moves could make markets less useful.

In the stock market, price transparency is required in order to give retail investors as much information as professional buyers and sellers. In the derivatives markets, where there are few retail participants, regulators want to remove the risks to the financial system of a dealer going bust. The impact that price moves in credit derivatives – a form of insurance on the default of a company or a country – can have on bond or stock markets is another factor.

The controversy about trading Greek CDS and whether such derivatives have worsened Greece’s financial woes have added fuel to the debate. The focus on making OTC derivatives “safer” began, however, in 2008, after the collapse of Bear Stearns and Lehman Brothers highlighted “counterparty risks”. The US government had to cough up $180bn to bail out AIG after the insurer nearly collapsed on unexpected risks from derivatives deals.

Germany and France this week called on the European Union to only allow derivatives transactions on exchanges, electronic trading platforms and through centralised clearing houses. In the US there have been similar calls.

“Who would not want the transparency [for derivatives] that you have in the stock market?” said Gary Gensler, chairman of the Commodity Futures and Trade Commission, and one of the regulators in the US who has become a strong advocate of big reforms. “The only parties that benefit from a lack of transparency are Wall Street dealers.”

Theo Lubke, head of markets infrastructure division at the Federal Reserve Bank of New York, which has been spearheading regulatory efforts to improve information and the structure of derivatives markets, said that recent uncertainty around the trading in Greek CDS had highlighted the importance of greater transparency. “The lack of good knowledge by regulators [about OTC derivatives] is not a tenable long-term equilibrium,” he added.

The big derivatives dealers – which include the largest Wall Street banks Mr Gensler referred to – say requirements to publish trading volumes and prices for the privately-traded derivatives markets in a similar way to stock markets could drain liquidity from large parts of derivatives, and result in price information which is inaccurate or misleading.

Dealers often refer to the corporate bond market, also a privately-traded, OTC market. Regulators mandated reporting the trades of US corporate bonds to the Trade Reporting and Compliance Engine (Trace). Many dealers say the need to make trades public made trading corporate bonds more difficult, because rivals could detect what positions were held. Dealers say the resulting reduction in liquidity was one reason CDS grew so strongly in the past decade, as this market offered a way to trade more privately.

In addition, there are concerns that a “tape” just does not work for some types of financial instrument. An example is the market for interest rate swaps. Prices for the one five-year swap do not necessary offer any useful guide for the price of others, because many details – such as the date companies want them to kick in – vary. Such lack of comparability is referred to as “fungibility” in market jargon.

“Trace, or a tape, all involve financial instruments that are fungible,” said Don Thompson, associate general counsel at JPMorgan Chase. He said this was not the case for many OTC derivatives, meaning that price information “could be misleading”.

Regulators, however, say these effects are exaggerated, and obstacles can increasingly be overcome with technology. “Academic studies not funded by the industry [have found] that Trace has led to benefits for corporate bond markets,” said Mr Lubke.

The battle now is over determining how far the drive for price trading information will go. CDS are among the most likely to see this happen: the push to make these derivatives clearable since the Lehman collapse has resulted in changed standards, which has made them more “fungible”.

Already, the biggest derivatives dealers and investors have agreed to submit details of price sources for credit, interest rate and equity derivatives to regulators by the end of March. They will then analyse the costs and benefits of increased transparency for different types of derivatives by August.

The outcome is far from clear, however.

“There is a wide bid/offer around how quickly trade information will get disseminated,” said Andrew Feldstein, chief executive of BlueMountain Capital Management, at a conference this week. He added that views ranged from reporting within minutes of trades to reporting the following day. “I’m optimistic that this is a solvable problem.”

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