Banks Racing to Pare Swaps Holdings Ahead of Rules, Goldman Says

July 9 (Bloomberg) -- Wall Street banks are racing to simplify their swaps holdings before new rules make it more costly to own the derivatives starting in 2017, according to a Goldman Sachs Group Inc. executive.

They’re doing so increasingly through a process known as compression, said Andy Hudis, a managing director at Goldman Sachs who runs the credit valuation adjustment desk in London. Through this technique, offsetting transactions are eliminated so that a bank can reduce, say, 100 trades into 10 that give the identical position.

Swaps helped cause and intensify the 2008 financial crisis given the opaque entanglements they created among banks. In response, global regulators took a series of steps to reduce risk, including boosting the amount of money they have to set aside to guarantee the transactions. Compression can help them reduce that burden, while also reducing market complexity.

“For dealers, this is an extremely important topic right now,” Hudis said today during a presentation sponsored by Bloomberg Markets magazine and LCH.Clearnet Ltd. Compressing swaps to reduce the outstanding value in notional terms for banks is among the top three goals among Wall Street firms now, he said. Notional values don’t represent actual money that has changed hands and determine payment flows under swap contracts.

JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp., Goldman Sachs and Morgan Stanley were the five largest U.S. swaps dealers as of Dec. 31, according to the Office of the Comptroller of the Currency. Bloomberg News parent Bloomberg LP runs a swap-execution facility where the derivatives trade. Since 2003, more than $400 trillion in notional value of interest-rate swaps has been compressed, according to TriOptima, an ICAP Plc division that pioneered the technique.

Market Safeguards

Improving the safety and structure of over-the-counter derivatives was a central goal of global regulators after swaps, the largest segment of the $710 trillion market, helped cause the financial crisis and then worsened its aftermath. Netting down swaps by compression is encouraged in both the Dodd-Frank Act in the U.S. and the European Market Infrastructure Regulation legislation.

“So now it’s the law,” Stephen O’Connor, chairman of the International Swaps & Derivatives Association, the industry’s lobbying and trade group, said during the same presentation today. “While the law generally gets people’s attention,” the new capital rules from the Basel Committee on Banking Supervision are what is really driving the demand, he added.

While compressing trades has been around for over a decade, “there is a new sense of urgency from market participants,” he said.

More Capital

That’s because under Basel III rules starting in 2017, banks will face higher capital requirements for their swaps activity related to the amount of leverage they use in day-to-day operations and the cash and securities they deposit at clearinghouses that’s used in case of a default.

For example, a bank with swaps worth $1 trillion in notional value on its books could face $180 million in minimum capital charges under the leverage ratio in some cases, said Dan Maguire, global head of LCH.Clearnet’s SwapClear service.

“That’s a pretty sizable amount,” he said, speaking during the presentation today.

International regulators are trying to safeguard trades and bring more openness to a market whose secrecy and sheer size overwhelmed authorities 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. Basel is made up of regulators from 27 of the world’s largest economies and sets international bank supervisory guidelines.

If banks hadn’t been netting down their trades since 2003 some in the industry estimate there could now be $1 quadrillion of the contracts outstanding, according to ISDA’s O’Connor.

“If that number even exists,” he said.

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To contact the editors responsible for this story: Nick Baker at Michael P. Regan