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Senate Amendment Would Again Take Phones Out of Swap Trading

Senator Tom Harkin
Senator Tom Harkin, a Democrat from Iowa. Photographer: Andrew Harrer/Bloomberg

Senators Tom Harkin and Maria Cantwell introduced an amendment to the financial reform bill to ensure electronic trading, not phone transactions, are used to buy and sell most swaps after the legislation was changed last month.

To improve the private derivatives market structure, lawmakers have focused on requiring that most swap trades move through clearinghouses. Additionally, contracts between banks and major swaps users would be subjected to mandates on how they can be traded, either through regulated exchanges such as Chicago-based CME Group Inc. or on so-called swap execution facilities.

How the contracts are allowed to be traded under the new law is one of the most contentious areas of regulation for banks because of the wide profit margin they make by keeping their prices for interest-rate, credit-default and other swaps private. This would be at least the fifth change in how the contracts could trade since reform was begun in the House last year.

“The objective of the amendment is to make sure the legislation substantially reforms the over-the-counter trading of swaps to ensure transparency and openness,” Harkin, Democrat of Iowa, said in an e-mailed statement. “The amendment addresses some concerns that have existed regarding whether we can get to these objectives without electronic trading.”

The White House listed the removal of swap trading requirements as one of “The 10 Most Wanted Lobbyist Loopholes” in financial reform, according to a May 4 blog posting on

‘Not Everyone Likes Transparency’

“Expect amendments to eliminate this trading requirement,” White House Communications Director Dan Pfeiffer wrote in the post. “Not everyone likes transparency. Today, the big derivatives dealers make big profits by charging end-users extra spreads and hidden fees, and they don’t want that to change.”

The Harkin and Cantwell amendment would define a swap execution facility as “an electronic trading system with pre-trade and post-trade transparency in which multiple participants have the ability to execute or trade swaps by accepting bids and offers.” A change made to the bill in April broadened the types of allowable trades to include those done over the phone.

Grant Gustafson, a spokesman for Harkin, declined to comment on when the Senate may vote on the amendment.

Mostly by Phone

Swaps now are mostly traded via phone by banks and their customers. Interdealer brokers such as ICAP Plc of London and trading systems like Tradeweb LLC also use hybrid systems that combine phone and electronic screens to give their clients access to market prices.

“Markets function best when there is real-time price transparency,” Cantwell, Democrat from Washington, said in an emailed statement. “We need the same level of transparency in the swap market as we have in the commodity future and stock markets.”

Congress is crafting legislation to regulate the $615 trillion over-the-counter derivatives market for the first time in its 30-year history after the contracts complicated efforts to resolve the financial crisis. A major component of that would be to process most swap trades in a clearinghouse, which is capitalized by its members, requires daily margining to keep accounts current and provides regulators with market prices and positions.

One-Word Deletion

In late April, a one-word deletion was made to the 1,565-page Senate financial reform bill that could help banks and inter-dealer brokers maintain phone trading in the unregulated market. The word “trading” was deleted from the term “trading facility,” which could have been interpreted to refer to the same term in the Commodity Exchange Act.

A “trading facility” as defined under the act prohibits telephone transactions. The banks that dominate the market profit by relying on telephone-based trading because it’s less transparent than electronic-trading systems, Darrell Duffie, a finance professor at Stanford University in California, said at the time.

At stake is trading revenue in unregulated markets that last year generated an estimated $28 billion for five U.S. dealers including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley, according to reports from the New York-based banks collected by the Federal Reserve and people familiar with banks’ income.

The Senate bill allowing phone trading creates a framework for swaps to be traded competitively based on price, service and technology options, according to Christopher Giancarlo, chairman of the Wholesale Markets Brokers’ Association Americas. “A full range of communications methods” should be allowed and would increase the amount of cleared trades in the market, Giancarlo said last month. He is also the executive vice president of GFI Group Inc., an inter-dealer broker.

Dodd Provisions

Harkin and Cantwell’s amended definition of swap execution facility is very similar to language introduced earlier this year by Senator Christopher Dodd, chairman of the Senate Banking Committee and a Democrat from Connecticut. The part of his bill dealing with derivatives was replaced by a version written by Sen. Blanche Lincoln, chairman of the Senate Agriculture Committee and a Democrat from Arkansas.

Derivatives are financial instruments based on the value of another security or underlying asset such as oil or interest rates.

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