Tuesday, April 13, 2010

The derivatives ding-dong waiting in the Dodd bill

Looks like the flagship of US financial reform won’t have plain sailing after all.

Tuesday brought an odd bit of shadow-boxing over where to park derivatives trading in the post-Lehman age. Something to watch, as Senator Chris Dodd’s bill gets ready for actual legislative debate late this month, according to the Washington Post.

In the blue corner, Treasury Sec Tim Geithner makes the case for putting over-the-counter products through centralised clearing:

Transparency will lower costs for users of derivatives, such as industrial or agriculture companies, allowing them to more effectively manage their risk. It will enable regulators to more effectively monitor risks of all significant derivatives players and financial institutions, and prevent fraud, manipulation and abuse. And by bringing standardized derivatives into central clearing houses and trading facilities, the Senate bill would reduce the risk that the derivatives market will again threaten the entire financial system.

But — in the red corner, Republican Senator Judd Gregg alleges there’s a liquidity risk:

Congress is currently considering several proposals that each provide important steps to address transparency and potential systemic risk in the OTC market.

These steps include reporting of trades, increased opportunity for clearing, sufficient cushion in the form of risk-based margin or collateral, heightened capital requirements, as well as detailed market participant record keeping for ongoing regulatory review.

All of the current proposals, however, go one step too far by mandating that trades of these complex financial risk- management tools be executed through an exchange. Such a requirement would result in significant and harmful economic costs without providing the intended safety and soundness benefits.

Mandatory exchange trading would reduce market liquidity and increase execution costs for the ultimate end-user of these swaps. Advocates for mandated exchange trading want to decrease bid-ask spreads, which would theoretically lower the cost of these products, but they fail to understand the market sensitivities.

Mandating real-time dissemination of swap transaction price and quote data will require market participants to announce their trading interests to the entire market and allow others to step in front of their trades, moving the market against their hedges. In such an environment, market liquidity for swap transactions will decrease dramatically, if not disappear altogether.

Why, the jargon couldn’t have been more pitch-perfect if derivatives traders had written Senator Gregg’s piece themselves. Surprise, surprise — private derivatives trading brings home quite a bit of bacon for JP Morgan et al. at the moment, as BusinessWeek reports.

But, er, hang on — Geithner’s central clearing-houses aren’t the same as exchanges, surely. And while Senator Gregg would prefer ‘industry migration’ to transparency rather than a specific mandate — that didn’t happen before, so why would it now? We’d note that central credit default swap clearing has already begun in (whisper it) France — with state backing.

At any rate, sure, market liquidity is a problem — but solvency in the shadow of mispriced derivatives is a slightly more pressing matter. Ask AIG’s CDS writers. Indeed, Senator Gregg, ask the US taxpayers who rescued America’s largest insurer.

At any rate, the White House is starting to set out red lines on derivatives reform, the WSJ says, and the Republicans would appear to be joining battle elsewhere — on too big to fail.

One to watch, as we said. And trust the International Monetary Fund to pick this moment to come out in favour of centralised clearing.

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