Swaps Rule Sends Wall Street Into Clearing Limbo: Credit Markets

The securities industry misinterpreted rules it assumed allowed as many as nine months to start moving swaps into clearinghouses that are meant to limit risks to the financial system.

Firms dealing in $648 trillion of outstanding swaps contracts expected that trading during a phase-in period wouldn’t need to be processed by central clearinghouses, according to an Oct. 5 e-mail sent to clients by Davis Polk & Wardwell LLP, which represents the Securities Industry and Financial Markets Association. They were wrong, misreading one sentence in 17,000 words of regulation.

Unless lobbyists convince the Commodity Futures Trading Commission to soften the deadlines, derivatives users that speculate on or hedge against losses on everything from changes in interest rates to corporate bankruptcies may need to find cash and Treasuries to back the trades sooner than they anticipated. The 2010 Dodd-Frank Act is requiring trades be moved to the central counterparties to limit the kinds of risks that fueled panic during the 2008 credit crisis.

“Customers are scrambling to get arrangements with clearing brokers, so this is going to increase the operational complexity and challenge,” said Craig Pirrong, a finance professor at the University of Houston. Customers will have to find so-called margin that clearinghouses require to cushion against losses on swaps “that are all of a sudden going to be cleared,” he said, “so there’s the liquidity demand that’s also going to be fairly acute.”

Curbing Risk

Clearinghouses, which will process trades that are typically managed bilaterally between dealers and their customers, may also face a flood of volume they didn’t anticipate as each deadline kicks in, Pirrong said.

Clearing the trades sooner than expected may soak up as much as $50 billion in additional collateral for swaps users, according to Anshuman Jaswal, senior analyst at financial research firm Celent in New York.

The CFTC may clarify the rules before they are completed as early as next month, though it’s too early to know what changes may be made, Commissioner Scott O’Malia said in a telephone interview.

Confused Reaction

The swaps industry reacted with “confusion about what the standard is,” he said. “I understand the staff is working on a recommendation but I don’t know what form that will take.”

Liz Pierce, a Sifma spokeswoman, referred questions to Davis Polk. Katie Harter, a Davis Polk spokeswoman, declined to comment.

Elsewhere in credit markets, bonds of New York-based Morgan Stanley are the most actively traded dollar-denominated corporate securities by dealers today, with 153 trades of $1 million or more as of 11:22 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The firm sold $2 billion of 4.875 percent, 10-year notes yesterday, Bloomberg data show. The subordinated securities rose 0.9 cent from the issue price to 100.5 cents on the dollar to yield 4.81 percent as of 11:18 a.m. in New York, Trace data show.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 1.5 basis points to 10.84 basis points as of 11:15 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Clearing Mix-Up

The cost of protecting corporate bonds from default in the U.S. increased for a second day. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbed 1.7 basis points to a mid-price of 92.6 basis points as of 11:08 a.m. in New York, according to prices compiled by Bloomberg. The index ended Oct. 17 at the lowest level in almost a month.

The index typically rises as investor confidence deteriorates and falls as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The mix-up surrounding when most swaps would need to be cleared arose after the CFTC established two separate deadlines: one setting an effective date in which the clearing mandate begins and another by which market participants must be in compliance.

‘Mistaken Interpretation’

Three categories of swaps users were established, giving them 90 days, 180 days, or 270 days after the effective date to comply, according to a June 30 notice by the CFTC. The regulator, along with the U.S. Securities and Exchange Commission, is writing rules required by the Dodd-Frank Act to limit risk and boost transparency in swaps after the market exacerbated the credit crisis.

“Market participants have assumed that a trade entered into before the applicable compliance date, but during this phase-in period, did not need to be cleared,” Gabriel Rosenberg, an associate in Davis Polk’s financial institutions group, said in the Oct. 5 e-mail obtained by Bloomberg News.

Delta Strategy Group, a lobbying firm that represents swaps users, agreed.

“The mistaken interpretation was that the mandate applies to swaps entered into after the respective phasing period begins,” it wrote to clients in an Oct. 9 note. Delta Strategy is confident the CFTC will amend the rule to not require clearing during the phase-in periods, said Scott Parsons, a managing principal in the Washington-based group.

‘Monumental Task’

“This is something we’re sorting through,” CFTC Chairman Gary Gensler said in an Oct. 10 speech in Washington at George Washington University, citing the Davis Polk e-mail. “We’re trying to phase this in in a way that works, in a balanced way.”

The swaps industry assumed it had been given the various implementation times to complete documents between banks and their clients for the clearing process, said Supurna VedBrat, co-head of market structure and electronic trading at BlackRock Inc. BlackRock, the world’s largest money manager with $3.67 trillion of assets as of Sept. 30, has hundreds of accounts it has to bring into compliance, “a monumental task,” she said.

“This is one of the biggest changes the financial markets have seen in a very, very long time,” she said. “We’re going from a world where there was a bilateral relationship between the counterparty and the fund to a relationship between six or seven entities to execute the same trade.”

Cost Gap

The majority of BlackRock’s swaps are in accounts that wouldn’t have to be in compliance until 270 days after the effective date, while some would need to be within 90 days, VedBrat said.

The cost of executing swaps between two private parties varies from those that will be backed by a clearinghouse because they use different assumptions for risks related to the failure of counterparties, the ease of finding trading partners and whether margin will be required to back the trade.

“We will get some differentiation in prices,” said VedBrat. “Because of that difference, it’s not that easy to move the bilateral trades into a cleared environment because they would have to be a price adjustment.”

The CFTC’s O’Malia said it would be too confusing for market users to enter into swaps bilaterally that would then be cleared at some point in the future. “There’s a lot of ambiguity to how the practice would be in that interim period, and that’s confused a lot of people,” he said. O’Malia said he supports having the 90, 180 and 270 days be a grace period for clearing with the mandate to start the next day.

‘Unintended Consequences’

With clearing compliance still a work in progress, dealers will “still enter new contracts, but it would impact the volume of contracts they’d be comfortable with,” Jaswal said in a telephone interview. Having to clear shifts the focus to “optimize your resources and make sure you’re able to meet the CFTC guidelines,” and may diminish trading volume by as much as 50 percent, he said.

The so-called notional value of contracts in the market doesn’t represent actual money that has changed hands and is used to calculate periodic contract payments.

If the CFTC rule isn’t softened, it will prove “expensive and risky” for swaps users, Pirrong said.

“This is another example of the unintended consequences of Dodd-Frank,” he said. “We have sorcerer’s apprentices waving their wands to bring all these mandates into the effect, and now we’re having to live with the consequences.”

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