Proposed financial regulatory reforms weigh on Chicago firms
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By Lynne Marek and Paul Merrion
May 25, 2010
(Crain’s) — While the financial regulatory reform bills moving through Congress are mainly aimed at New York bankers blamed for the economic crisis, Chicago’s financial firms will also feel the increased regulatory heat.
Regardless of how Senate and House versions of the bills are reconciled, the federal government will be more closely monitoring and curtailing the banking, asset management and financial securities trading industries.
In Chicago, the new law is likely to have a big impact on CME Group Inc., which operates the biggest U.S. derivatives market through its financial exchanges, and the trading and asset management industries that have grown up around it.
Both bills would require that trading of over-the-counter derivatives now sold in private transactions be shifted to public exchanges or yet-to-be-developed “swap execution facilities” and centrally cleared by entities that operate alongside the exchanges.
Exchanges would add transparency to a largely unregulated and unseen market, while some form of clearinghouse would reduce the risk to the entire financial system in the event one or a few players failed.
While the mandate could increase order flow through the CME’s exchanges and clearing facilities, Chicago-based Raymond James & Associates Inc. analyst Patrick O’Shaughnessy doesn’t expect it to be a windfall for CME.
Dealers in the OTC market are likely to seek out the least transparent options for trading and likely will find alternatives such as the new electronic execution facilities, Mr. O’Shaughnessy says.
The CME is more likely to go after the new OTC clearing business because it already has experience providing such services for some OTC derivatives through its ClearPort system, he says.
Still, “the margins in the business are going to be relatively disappointing,” mainly because of competition, Mr. O’Shaughnessy says.
Chicago’s trading firms could be affected by some of the curbs on trading, such as limits on the number of contracts a single trader can hold in a single category, such as corn futures.
The Senate bill also would require banks to halt trading for their own accounts and spin off derivatives trading units.
Under both the Senate and House bills, the exchanges and traders will face SEC and Commodity Futures Trading Commission regulators with greater authority to monitor and police the industry.
Chicago’s hedge fund community is likely to feel the impact of new Securities and Exchange Commission registration requirements because the city has a larger share of smaller hedge funds that may have been exempt from registering as investment advisers in the past.
While bigger local hedge funds, such as Citadel Investment Group LLC, have mainly already registered — because current law mandates it for firms with 15 or more funds or because institutional investors have requested it — smaller funds have avoided the additional cost or work, says Scott Moehrke, a Kirkland & Ellis LLP partner in Chicago who heads of the firm’s investment management practice group.
Hedge funds with $150 million or more under management will have to register if the provision in the House bill prevails or $100 million or more if the corresponding Senate bill section prevails.
“It certainly means that they will have regulatory scrutiny they haven’t had in the past,” Mr. Moehrke says. “They’ll need to formalize their compliance procedures.”
Private-equity funds and venture capital funds would qualify for an exemption under the Senate bill, but under the House bill they would be required to register just like the hedge funds if they have more than $150 million under management.
Large private-equity firms, such as Madison Dearborn Partners LLC, already disclose information to the SEC and would be less affected.
What may be more relevant to private-equity firms is a newly introduced bill that would change the tax treatment of so-called carried interest, or the benefit the firms reap on their equity investments over time.
Under the proposals, that gain would be taxed at a higher rate starting at about 25% and rising to 35%, as opposed to the 15% capital gains rate.
While Chicago’s biggest bank, Northern Trust Corp., declined to comment on the potential impact of the legislative proposals, the state’s small community banks, which account for almost 90% of the banks in Illinois, have mixed reactions to the proposals.
A restructuring of federal deposit insurance fees will shift more of the burden to big banks, saving smaller banks $4.5 billion nationwide over three years, according to the Independent Community Bankers Assn., an industry group in Washington, D.C.
“We’re not opposed to the bill,” said Kraig Lounsberry, senior vice-president of government relations for the Community Bankers Assn. of Illinois, a sister group in Springfield. “Change in assessments is great for community banks.”
Smaller banks hope that a reconciliation of the House and Senate versions will delete rules for credit and debit card issuers added to the bill last week by Sen. Richard Durbin, D-Ill.
Aimed at lowering the fees that retailers are charged by industry giants Visa and MasterCard, Mr. Durbin’s so-called “swipe fee” amendment exempts smaller banks.
Still, those banks see problems ahead.
“The big guys are going to negotiate with the big banks” and set lower fees than what smaller banks are charging, Mr. Lounsberry said. “If merchants can pick and choose what to accept, they’ll take Bank of America’s card. There are a lot of questions about how this will work.”
In Mr. Durbin’s view, they are mischaracterizing his bill.
The swipe-fee amendment also creates potential problems for smaller card companies, such as Riverwoods-based Discover Financial Services Inc. — issuer of Discover and Diner’s Club cards.
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