Tuesday, April 13, 2010

IMF Proposes Taxing Derivative Dealers In Lieu Of Clearing Mandate

Original posted on the Dow Jones wire service:

The International Monetary Fund cautioned Tuesday against new legislation that would force dealer banks to clear their swap trades, and instead urged policymakers to consider imposing a risk-based tax on dealers as an alternative way to encourage central clearing.

The IMF's suggestion differs from proposals under consideration both by the U.S. Congress and the European Commission which would force banks to submit some of their routine contracts to a clearinghouse, which guarantees trades for both parties in case one side defaults.

"A mandate to centrally clear standardized contracts is a less desirable solution because the need to post potentially large amounts of margin will be disruptive if done at once," the IMF said in one of the chapters that form part of the semi-annual Global Financial Stability Report. "However, if other incentives do not generate enough movement, a mandate may be necessary to overcome market participant fears of being first movers."

The IMF's report comes out just as the U.S. Senate is returning from Easter recess and plans to take action on a bill to overhaul the financial system as a response to the 2008 crisis.

A key part of that will entail new rules for over-the-counter derivatives, which are not traded on regulated exchanges. Big banks make money by structuring the deals and selling swaps to one another, or to firms seeking to hedge their exposure to things like interest-rate fluctuations or price moves in the energy markets. Moving some of these derivatives off the books of the banks and into clearinghouse is a central part of the bill that many lawmakers and regulators believe will help reduce risk in the system, although the move also will likely eat into Wall Street's profits.

The IMF in its report endorsed the concept of clearing for some of these contracts, but offered an alternative approach to getting the dealers to move in that direction by charging them a tax. The tax would be tied to the risks that their derivative books pose to their counterparties and to the whole financial system.

"Some extra incentives may be required," John Kiff, senior financial sector expert in the IMF's monetary and capital markets department, told reporters at a briefing to discuss the chapter.

"In that case, we suggest charging dealers a fee tied to the risks that their derivative positions impose on their counterparties," said Kiff, one of the authors of the chapter.

In the report, the IMF said the tax rate "would need to be calibrated to provide enough incentive to move contracts to central counterparties, but not so high as to overly burden dealers as they attempt to deleverage and accommodate the more stringent regulations likely to be enacted. Also, the timing of such charges would need to be carefully considered."

If in fact Europe and the U.S. do decide to press forward with clearing mandates, the IMF said, then those mandates should be "phased in gradually."

Clearing has been embraced by many international regulators as a solution to help address systemic risk, but deciding who should be required to clear remains a controversial question.

Legislation that was approved by the U.S. House in December only targets swap dealers and major traders, but exempts firms that use swaps to hedge risks known as "end-users" who fear they won't be able to afford to post margin to a clearinghouse. The U.S. Senate bill also contains exemptions, although they are less generous.

Commodity Futures Trading Commission Chairman Gary Gensler has argued that the exemptions in the bill are too broad and could create loopholes.

The IMF in its report said "there does seem to be good case to carve out real hedging transactions by end-users," but it noted that enforcing the exemption could prove difficult because it would require the dealers who sell the end-users the swaps to "be highly knowledgeable about the activities of their customers."

Also on the table for Congress to consider is another proposal to force some swaps not only to be cleared, but also to be traded on regulated platforms in an effort to bolster price transparency. Gensler has urged Congress to impose both clearing and trading mandates, saying they are equally important.

The IMF's report took a different view, however, saying clearing should be the focus for now because exchange-trading requires a certain amount of liquidity, and structuring the contracts to be more "standard" for clearing won't necessarily guarantee a move to exchanges.

"The legislative and regulatory focus should be first on centralized clearing and let standardization provide the natural incentives for exchange trading," the report said.

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