Exchanges see bonanza in OTC overhaul
By Anuj Gangahar and Aline van Duyn
Published: May 15 2009 03:00 | Last updated: May 15 2009 03:00
Some of the big derivatives dealers breathed a sigh of relief when they saw the details of this week's sweeping plan from the Obama administration to regulate over-the-counter derivatives.
With parts of the $680,000bn market blamed for exacerbating the financial crisis, large swathes of which are opaque even to regulators, there had been draft proposals flying around Washington that would have had an even more far-reaching effect than the current plans. In particular, the proposals unveiled by Tim Geithner, US Treasury secretary, on Wednesday, include plans for "the encouragement of regulated institutions to make greater use of regulated exchange-traded derivatives".
"Exchange trading of all derivatives has not been made mandatory, which is a big relief for the industry," said an executive at one large derivatives dealer.
Nevertheless, the proposals have plenty of other details which will significantly overhaul the industry, which has grown to one of the most profitable parts of Wall Street and the City of London, and which has managed to fight off calls for stringent regulation for the last two decades.
The big banks, which have long dominated the over-the-counter (OTC) derivatives market, have already moved to adopt some of the proposed changes, which include changes in US laws to require the clearing of all standardised OTC derivatives through regulated central counterparties.
Bankers said that the collapse of Lehman Brothers last September was a key turning point as it showed how vulnerable the financial system was to meltdown if one dealer went under, because most other dealers were exposed to such a default through trillions of dollars of derivatives contracts.
Since then, large amounts of interest-rate swaps - the largest OTC market - have been shifted to centralised clearing, as have commodities, particularly in the energy sector. Efforts are also underway to clear credit default swaps. These are regarded as the riskiest part of the derivatives market and are particularly under scrutiny as they led to the collapse of AIG.
Even without mandatory exchange trading, which is being encouraged, exchanges are expected to be among the main beneficiaries of the derivatives industry shifts. So are other electronic trading systems, such as Tradeweb, which is used in the swaps market.
"Expanding the scope of the mandatory clearing through central clearing counterparty [beyond credit derivatives] is a material step up in the shift from OTC to on-exchange," said Dirk Hoffmann-Becking, analyst at Sanford Bernstein.
For years, exchanges have been trying to break into the vast OTC market without upsetting their largest customers - the banks.
Now, they can press harder and argue they are acting the way regulators want them to. However, other electronic trading systems may also benefit and there could be tussle between the exchanges and smaller electronic rivals.
Shares of the CME Group and the Intercontinental Exchange, the exchanges best positioned to take advantage of moves to introduce a central clearer for a range of derivative products, gained strongly yesterday, adding to gains on Wednesday. CME shares are up over 16 per cent for the week.
The losers are likely to be the big dealers.
"In the banking sector, these developments are significantly negative," said Mr Hoffman-Becking. "Bid-offer spreads on an exchange trading platform are always much narrower than they are OTC due to higher transparency."
The full impact of the new rules is still not clear, however. First of all, the response from European regulators will be key (see below). The derivatives markets are global and any weaknesses in regulation in one part of the world could shift activity to another.
"The whole regulatory approach needs to be global, otherwise activity will just shift elsewhere," said Larry Tabb, of the Tabb Group consultancy. "At the moment it is jawboning, and the words need to be followed through with actions in the US, Europe and elsewhere."
Second, the proposed regulatory changes apply to "derivatives dealers and all other firms who create large exposures to counterparties". Whether that includes companies using derivatives for hedging is not clear. Also, there are many smaller investors active in the market that do not have sophisticated technology or risk-management systems set up.
Third, there are concerns that a plethora of clearing houses could increase risks.
Recent research by Darrell Duffie, professor in finance at the Stanford Graduate School of Business, found that risks could be increased if clearing was only applied to one category of OTC derivatives. His study focused on the credit default swaps market, where centralised clearing has already started.
"Our results make it clear that regulators and dealers should carefully consider the trade-offs involved in carving out a particular class of derivatives, such as credit default swaps, for clearing," the research says. The reason is that the big dealers in OTC derivatives offset many of their risk positions. But if one large slice of risk is suddenly removed from that pie, the remaining risks could potentially be larger.
Hence key questions include: what exactly ends up being classified as "standardised" and how quickly are different types of OTC derivatives forced to move to centralised clearing?
Though the industry is appearing supportive, it is clear there is a degree of caution.
"Our members continue to support efforts to reduce systemic risk, strengthen the infrastructure for derivatives transactions, and improve regulatory transparency," said Tim Ryan, president of the Securities Industry and Financial Markets Association (SIFMA). "It is important that new regulatory measures preserve the usefulness of derivatives as risk management tools for American businesses."
Copyright The Financial Times Limited 2009 |
