Swap Reform to Increase Competition, Cut Bank Profit

Regulatory reform of over-the-counter derivatives should open the market to more banks while lowering the swap-trading profits of major dealers, according to Citadel LLC.

The Dodd-Frank Act, which became law in July, requires most swap trades in the $615 trillion OTC derivatives market to be processed by clearinghouses in an effort to stem systemic risk. With a clearinghouse on the other side of every trade, banks with less capital on their balance sheets should have access to the market previously dominated by firms such as JPMorgan Chase & Co., Deutsche Bank AG and Goldman Sachs Group Inc.

“Introducing competition and transparency will change the business practices of all market participants,” Kenneth Griffin, founder of Citadel, said today at a symposium at the Federal Reserve Bank of Chicago. “Pension funds, asset managers and corporations who rely on this important financial tool will be better equipped to manage balance sheets.”

Congress sought to regulate OTC derivatives, including swaps, after the trades complicated efforts to solve the financial crisis. Regulators and market participants couldn’t easily determine how interconnected banks had become through the contracts. Establishing clearinghouses and transparent trading systems, such as so-called swap-execution facilities, are main components of the new rules.

Price Competition

Clearinghouses and other reforms will allow “new market-making entrants to compete on price and risk management rather than balance sheet,” according to a handout distributed by Chicago-based Citadel today at the symposium. Money managers previously sought to trade with only the largest banks because of their perceived low risk of default, Citadel said.

“Greater competition and price-discovery efficiency reduces bid-offer spreads thus reducing per-transaction revenues for dealers, potentially offset through an overall expansion in market volumes,” the handout said.

The top five U.S. commercial banks, including Goldman Sachs and JPMorgan, generated an estimated $28 billion in revenue from privately negotiated swaps in 2009, according to company reports collected by the Federal Reserve and people familiar with banks’ income sources.

“Moving our capital markets forward, we’re going to have to cut through emotional barriers,” Griffin said. “We have to resist a business as usual mindset.”

Swap Clearing

Citadel originally joined with CME Group Inc. as part of a plan to offer trading and clearing services of credit-default swaps. They dropped the trading component after Wall Street banks objected to both services being provided by one institution. Citadel is now one of six money managers working on CME’s credit-swap clearing plan.

The other firms are AllianceBernstein Holding LP, BlueMountain Capital Management LLC, D.E. Shaw & Co., Pacific Investment Management Co. and BlackRock Inc.

Clearinghouses, which are capitalized by their members, increase stability in OTC derivatives markets because they lessen the effect of a default by sharing risk among the members. They also use daily margining procedures to keep accounts current and allow regulators to see market positions and prices.

Membership Requirements

Only firms with a net worth of at least $5 billion are allowed to be members of the largest credit-default swap clearinghouse, Intercontinental Exchange Inc.’s ICE Trust. At CME Group’s venture, the minimum is $500 million. Both demand expertise in the market, including swap-trading desks that can provide prices for the contracts at the end of the day. Those prices are used to determine margin payments to the clearinghouse.

London’s LCH.Clearnet Ltd., the world’s largest interest-rate swap clearinghouse, requires clearing members to have a net worth of $5 billion and at least $1 trillion in outstanding business in swaps.

Some clearinghouses may not permit real-time transactions by brokers who aren’t members and some may not protect the anonymity of participants who execute trades through outside brokers, Citadel said.

This has the effect of “deterring or preventing buy-side participants from transacting with” smaller banks who can’t meet clearinghouse requirements, the company said.

Griffin said regulators and legislators need to be cautious about over-reaching.

“We need to be careful of where we’re drawing the line on consumer choice,” he said. “I think we’re drawing it too tight.”

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