Thursday, April 22, 2010

Derivatives traders search for ways to appease regulators

Posted in the FT by Aline van Duyn:

As Barack Obama, US president, took to the stage in New York to admonish Wall Street for spending millions of dollars on lobbying efforts to avoid tough new regulations, hundreds of derivatives industry participants were gathered on the other side of the US to mull over their futures.

Mr Obama is pushing for regulatory overhaul of financial markets, and reforms aimed at bringing derivatives and other complicated financial instruments “out of the dark”. These reforms are central to the administration’s efforts to prevent a repeat of the financial crisis.

Yet at the industry’s annual gathering, held by the International Swaps and Derivatives Association, the mood was hardly sombre: late-night parties have been organised at the grandest destination San Francisco has to offer – the luxurious hotel The Fairmont. Indeed, derivatives – unlike other markets at the centre of the financial crisis such as mortgage-back securities – remain a hugely profitable part of Wall Street’s business.

Nevertheless the industry’s focus has certainly shifted. Not long ago, these annual get-togethers were all about the creation of new products and the theme was focused on growth. Now, the industry is hard at work to find ways to meet regulators’ demands to shrink – or at least shrink the risks posed from the more than $400,000bn of contracts in privately-traded, over-the-counter (OTC) derivatives.

“ISDA and the OTC derivatives industry clearly support financial regulatory reform in order to ensure market stability and reduce systemic risk,” says Eraj Shirvani, chairman of ISDA and head of fixed income at Credit Suisse. “Our extensive, on-going work in three key areas – strengthening risk management through the use of clearing houses, improving transparency and building a robust operation infrastructure – underscores our commitment to making derivatives safer.”

The debate about the safety of derivatives was sparked by the realisation during the crisis that not only were some financial institutions “too big to fail”, having knock-on effects through the financial system, many had become hugely interconnected due to the widespread use of privately-traded derivatives. The more than $400,000bn worth of contracts outstanding on interest rate swaps, credit default swaps, currency forwards and numerous other types of over-the-counter derivatives had closely linked the dealers, which are usually the counterparties, to those contracts.

To tackle those systemic risks, efforts began to push OTC derivatives on to clearing houses. In that way, the risks of a counterparty defaulting are handled by the clearing house, which acts as a middle man and manages those risks.

Conrad Voldstad, a derivatives industry veteran who took over as chief executive of ISDA six months ago, says he found an industry “that was determined to make itself safer and more efficient”. He admits pressure from regulators was important. “It didn’t hurt to have regulators breathing down its back.”

Millions of dollars have been spent to improve safety – putting more contracts on to clearing houses, providing regulators with information about trades which are collected in information warehouses so they can track the bigger picture of derivatives exposures and risks, and improving the technology and systems underpinning trades so that they are quickly confirmed. The industry has promised regulators improvements at a rapid pace.

“When we have completed the tasks, we will no longer have issues like we did after the Lehman bankruptcy, when market participants and others worried about firms’ exposure to that credit event,” says Robert Pickel, ISDA’s executive vice-chairman. “And no longer will firms like AIG be able to amass so much exposure virtually unnoticed. Those two situations could simply never happen again.”

Two main clashpoints have emerged. On the one hand, the extent to which new rules for clearing will be applied to small financial institutions and non-financial companies. Those opposing exemptions say they act as loopholes to avoid regulation.

Even more important is the debate about exchange trading. It does not necessarily mean all contracts have to be traded on exchanges, but regulators such as Gary Gensler from the Commodity Futures Trading Commission are calling for high amounts of “post-trade transparency”. This could mean dealers have to publish trading prices and volumes right after trades are done – similar to the way trading goes on the equities markets.

The implications for banks’ bottom lines were highlighted last week by JPMorgan Chase, one of the biggest of a handful of dealers that dominate the privately traded derivatives markets. Jamie Dimon, JPMorgan’s chief executive, said the bank could lose up to $2bn in revenues if derivatives were forced to be traded on an exchange.

“Given its size and liquidity, price transparency in most of the OTC derivatives markets is comparable to or greater than the underlying cash markets,” says ISDA’s Mr Pickel. “That’s why we believe that we do not need – and derivatives end users are not asking for – mandatory exchange trading.”

He says immediate price reporting on an exchange – particularly of large trades or more illiquid products – makes it less likely that dealer firms will bid on those transactions.

“This adversely impacts liquidity, pricing and risk management. And to what effect? Very little, in our view. Exchange trading, it must be remembered, has nothing to do with reducing systemic risk or credit risk.”

But in the current climate, the industry will remain firmly in the spotlight. On Thursday, California’s treasurer – concerned about the use of derivatives to bet on the state’s financial condition – said legislation should make the market fully transparent and he urged that buyers of credit default swaps, which pay out when bonds default, should have to own the underlying securities – a measure the industry opposes.

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