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Tough Swap Standards Drive Up Trade Costs 92-Fold

Photographer: Scott Eells/Bloomberg

The toughened standards, hatched five years ago after derivative losses almost crashed the global economy, are meant to safeguard trades and bring more openness to a market whose secrecy and sheer size overwhelmed regulators in 2008. Close

The toughened standards, hatched five years ago after derivative losses almost crashed... Read More

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Photographer: Scott Eells/Bloomberg

The toughened standards, hatched five years ago after derivative losses almost crashed the global economy, are meant to safeguard trades and bring more openness to a market whose secrecy and sheer size overwhelmed regulators in 2008.

New rules aimed at making the world safer from blowups in the $693 trillion derivatives market are poised to drive up costs so much for retirement funds and other users that bankers say they do just the opposite.

The toughened standards, hatched five years ago after derivative losses almost crashed the global economy, are meant to safeguard trades and bring more openness to a market whose secrecy and sheer size overwhelmed regulators in 2008. Where swaps had been one-on-one deals before, now they would be backstopped by third parties in clearinghouses that ensure everyone can pay, with the aim of avoiding emergency bailouts and panic.

Rules being finalized by the Basel Committee on Banking Supervision in Switzerland will require banks to set aside more money in the event the swaps go bad. And not just a little bit more -- as much as 92 times, or 9,100 percent, more, according to calculations by three banks shared with Bloomberg News. The higher costs in turn may cause market participants to flee rather than take advantage of the clearinghouses, making it more difficult for those third-party guarantors.

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“Do we expect some firms to drop out? The short answer is yes,” said Will Rhode, director of fixed-income research at New York-based Tabb Group LLC. “To have more members of clearinghouses is better because then you have better resources” in a crisis, he said. Allowing instability to increase “is not an option,” he said.

‘Uneconomical’ Proposal

Bank advocates including the International Swaps and Derivatives Association Inc., a group representing the world’s largest banks, argued in a September letter to the Basel committee that its proposal was overkill and unfairly cost them too much money. The committee’s plan would “result in capital requirements that make clearing uneconomical,” the groups said.

Attempting to Defuse Derivatives

Swaps are what investors use to help guard against risk. They’re bought by pension plans and retirement funds to protect against fluctuations in interest rates, meaning they affect most people who own annuities. They’re used by the government to limit exposure in the mortgage market and cut home-loan costs.

Investors can also hedge an investment in a company by buying a swap that will pay them if a borrower stops paying its debts. They’re called swaps because investors and banks exchange, or swap, payments over time based on how interest rates move or how the creditworthiness of companies changes.

The contracts trade on swap execution facilities, including one run by Bloomberg LP, the parent of Bloomberg News. Other SEF owners include ICAP Plc and Tullett Prebon Plc. Bloomberg Financial Markets is an associate member of ISDA.

Fine Line

The Basel committee has a fine line to walk. The lack of capital to back up losses in the private swaps market was the main reason why the U.S. bailed out American International Group Inc. in September 2008, said Michael Barr, a law professor at the University of Michigan who helped write the Dodd-Frank law - - which aimed to make the U.S. financial system more transparent and resilient -- when he served as an assistant Treasury secretary from 2009 to 2010. Taxpayers ultimately provided $182.3 billion in bailout funds to AIG, since repaid.

“One of the early reforms we knew we wanted to take was moving the system toward central clearing where risk can be better observed and managed,” Barr said. “We were extremely focused at that time, as we dug the U.S. out of this disaster, to make the U.S. system safer.”

A representative of the Basel committee, which is made up of regulators from 27 of the world’s largest economies and sets international bank supervisory guidelines, declined to comment on the proposed clearinghouse regulations.

‘Enormous Sums’

Banks complain about higher capital requirements and use them as a reason to oppose oversight legislation, Barr said.

“The dealer banks were opposed to all the reforms in the Dodd-Frank Act and all the capital reforms on derivatives in Basel,” Barr said. “They spent enormous sums of money to fight us and didn’t stop when the Dodd-Frank Act was passed.”

In the past, banks have said that higher capital requirements would hurt their business and the economy -- predictions that haven’t come true.

In 2010, a lobbying group estimated that new banking rules requiring higher capital levels would erase 3.1 percent of gross domestic product in the U.S., euro region and Japan by 2015 because banks would bump up their loan rates or reduce how much they lent. While it’s impossible to know the effect stricter requirements have had, U.S. GDP expanded about 2.5 percent in the year that prediction was made, and 1.9 percent last year.

Safeguarding Banks

In 2009, when the Basel committee proposed increasing the amount of capital banks needed to hold in reserve for private derivatives trades by an average of eight times, the industry argued it would shrink the market by making the trades too expensive. Private derivatives trading has grown since then, according to the Bank for International Settlements.

To Darrell Duffie, a Stanford University finance professor, shielding the financial system from collapse is a bigger concern than whether pension funds and insurance companies can hedge their risk.

“The first priority is to keep the banks properly capitalized,” Duffie said.

If the Basel rules are adopted, pension plans might lose a tool to boost returns at a time when they’re bleeding money. State plans for government workers in the U.S. face an estimated $780 billion gap between what they promised and what they’ve saved, according to Wilshire Consulting. That doesn’t take into account the pension plans for the thousands of municipalities within the states that have their own deficits.

Regulating Pensions

To protect retirees’ money, the U.S. Labor Department regulates what types of investments that pension plans can make. Last year it said $6.8 trillion held by the funds could be invested in cleared swap transactions. The Teachers’ Retirement System for the State of Illinois and its 390,000 members, for example, had $808.4 million of interest-rate swaps as of mid-2013, according to its annual report.

“Swaps are one of the core ways that pensions manage their long-term interest-rate risk,” said Kevin McPartland, head of market structure and research at Greenwich Associates in Stamford, Connecticut. “If they suddenly can’t afford to do that, it would be a big hit to pensioners.”

Clearinghouses can make trading safer by “clearing” trades -- collecting cash or collateral to ensure participants are able to pay their obligations. Clearinghouses deal only with member firms, which act as intermediaries for their customers. To cover losses and keep the market from being disrupted by deadbeats, clearinghouses also pool cash and securities from the member dealers in what they call default funds.

Default Funds

There’s about $30 billion in default funds worldwide, according to Chris Cononico, president of GCSA LLC, a New York-based underwriter that’s seeking to insure derivatives clearinghouses.

The largest swaps clearinghouse owners are exchanges: CME Group Inc., IntercontinentalExchange Group Inc., London Stock Exchange Group Plc (LSE) and Deutsche Boerse AG.

Since banks act as customers’ gatekeepers to the clearinghouses, the Basel committee wants them to protect themselves -- and the global financial system -- by matching every dollar they contribute to the default fund with a dollar of capital.

If the rules were adopted, swaps dealers say that only the wealthiest investors would be able to use clearinghouses. Fewer members would mean eroded financial support for the clearinghouses, which are the last backstop before losses are borne by taxpayers.

Biggest Brokers

The world’s largest derivatives brokers at the end of 2013 were owned by Goldman Sachs Group Inc., JPMorgan Chase & Co. (JPM), Newedge Group SA, Deutsche Bank AG (DBK), Morgan Stanley (MS) and the Merrill Lynch division of Bank of America Corp. (BAC), according to the U.S. Commodity Futures Trading Commission.

Here’s how costs would change under the new rule, based on internal models from three major derivatives dealers provided to Bloomberg News under the condition that their identities wouldn’t be disclosed so they could openly discuss their business models.

Executives in a bank’s treasury department don’t allocate the firm’s money to trading desks without a guarantee that the profit on it will be about 10 percent to 15 percent a year after taxes, depending on the bank. In many cases, banks earn these returns by charging fees to clients.

Bank Models

In one bank’s internal model, a $100 million interest-rate swap between a dealer and its customer prior to the new Basel proposal would have meant that, before taxes, $14,750 in capital had to be set aside.

When the bank’s trading desk asks the firm’s treasury for $14,750 as part of the trade, the traders would have to earn $3,404 per year before taxes for as long as the swap was active. That’s in the old days.

The same $100 million swap would look different under the new proposal. As part of accepting that trade, the clearinghouse would require the bank to deposit $1.2 million into its default fund. Under the Basel committee proposal, the bank would have to have $1.2 million more capital.

According to the dealer bank, it would be required to generate more than $276,000 a year before taxes for that amount of capital. When charges such as the cost of funding and others are added to the trade, the tab balloons to $307,327 a year, the dealer said.

Punishing Intermediaries

That’s 90 times as much as the $3,404 before the new rules.

The projections by other market participants are similar. A second dealer who shared an internal model for a $100 million interest-rate swap said it would have required $2,769 a year before the Basel rules. Adding in the same associated costs as in the previous example leads to more than $256,000 a year, or 92 times more expensive.

A third major derivatives dealer that provided an internal model would have incurred $12,000 in capital costs under the old system, but would now face more than $253,000. That’s a 21-fold increase.

The added charges are alarming and punitive, Rhode of Tabb Group said.

“It’s counterintuitive if you introduce clearing to make the system more robust to punish the intermediaries necessary in that business,” he said.

These are simplified examples and don’t take into account how trades that offset can lower costs. They also assume a bank will pass all of the new costs on to the client. The bank executives contacted by Bloomberg News said their institutions hadn’t decided whether they’d do that.

A fourth executive said his firm would pass along the charge to clients. He added that the 10 biggest swaps dealers would probably decide to accommodate only the 200 largest investors in the world. He didn’t want to be identified speaking candidly about his firm’s plans.

By imposing such high costs, the Basel committee may be looking to curb the size of the cleared derivatives market, McPartland said.

“This is certainly going to meet that goal,” he said.

To contact the reporter on this story: Matthew Leising in New York at mleising@bloomberg.net

To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net Bob Ivry

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