How Wall Street Gamed Derivatives Reform
Forcing derivatives trading out of Wall Street's dark corners is one of the most contentious issues in the financial regulatory revamp debate. No mystery here: The five biggest U.S. dealers—JPMorgan Chase (JPM), Goldman Sachs (GS), Morgan Stanley (MS), Bank of America (BAC), and Citigroup (C)—generated an estimated $28 billion in revenue last year trading derivatives, according to Federal Reserve reports and people familiar with banks' financials.
Yet a sweeping overhaul, now in a House-Senate conference committee, likely won't have the transformative impact on the derivatives market some hope. (Derivatives are instruments that let companies hedge interest-rate risks or changes in commodity prices; they are also used for speculation.) Wall Street firms have known for more than a year that change is coming and have moved to protect their market role. Both the House and Senate bills mandate that most contracts in the unregulated $615 trillion over-the-counter derivatives market be traded on an exchange, or "swap execution facility," a creation of Congress so far only partially defined in the legislation. The measures also require third-party clearinghouses to process trades, guaranteeing the contracts.
For regulators and companies, this would be a big improvement. Banks now conduct most trades over the phone, keeping bid and ask prices private and spreads, the main driver of profits, high. Until the credit markets crashed, regulators had little idea how much derivatives-related debt banks were taking on or how interconnected they were.
Big bank derivatives dealers hope to keep a tight grip on the $25 trillion credit-default swaps market by sending a large volume of that business to ICE Trust, a U.S. clearinghouse owned by Atlanta's Intercontinental Exchange (ICE). ICE Trust has processed more than $5 trillion in credit-swap transactions since March 2009, while its sister operation in London, ICE Clear Europe, has done close to $3 trillion. And as of April, ICE Trust is sharing 50% of its profits with the Big Five and other large banks—ensuring continued order flow.
The profit-share agreement gives the banks an incentive to send all their trading to ICE Trust, says Mark Williams, who teaches finance at Boston University. In contrast, Chicago's CME Group (CME), the world's largest futures exchange, and LCH.Clearnet, Europe's largest clearinghouse, have taken only a fraction of the business. "Regulators need to monitor the relationship between these profit-sharing partners and Intercontinental," Williams says. "There's a potential conflict of interest." ICE Trust has an independent board of directors and advisory committee, counters spokeswoman Kelly Loeffler. Regulators in the U.S. and Europe have reviewed Intercontinental's governance and oversee its operations, she adds.
One of Congress's goals with derivatives legislation is to increase competition and lower the cost of hedging. ICE Trust, however, requires members to have a minimum net worth of $5 billion, a pricey admission ticket for smaller brokers.
The biggest players in the $349 trillion interest-rate swaps business, the largest OTC derivatives market, have also moved to protect how they buy and sell swaps with customers. One example: Goldman and nine other dealers own stakes in Tradeweb, a trading system majority-owned by Thomson Reuters (TRI). Tradeweb lets asset managers swap interest rates with dealers over an electronic system, or by phone. Earlier this month, Tradeweb said it would apply to become a swap execution facility. Created in 2005, Tradeweb has helped conduct more than 55,000 rate swaps, with more than $5 trillion in notional value. Inter-dealer brokers, firms that arrange trades between banks, could also enter the picture as swap facilities, says Christopher Giancarlo, chairman of the Wholesale Markets Brokers' Association Americas. Bloomberg, the parent company of Bloomberg Businessweek, which already has an interest-rate swap platform, also plans to register as a swap facility, says Ben MacDonald, Bloomberg's global head of fixed-income products.
The bottom line: The regulatory rewrite may dent the profits of Wall Street firms even as their stakes in trading and clearing companies benefit.