Big Banks Losing Grip on Derivatives

Paula Dwyer writes editorials on economics, finance and politics for Bloomberg View. She was London bureau chief for Businessweek and Washington economics editor for the New York Times, and is a co-author of “Take on the Street: How to Fight for Your Financial Future.”
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Unless you're employed by a derivatives trading desk at a large bank, here's some good news: The derivatives cabal is slowly but surely headed for a break-up.

The Commodity Futures Trading Commission yesterday approved new derivatives rules required under the 2010 Dodd-Frank financial reform law. They dictate how buyers and sellers must enter contracts, including credit-default swaps and interest-rate swaps, in the $633 trillion market.

Along with others the CFTC has approved, the rules will make the derivatives business safer, less costly for corporate end users, more competitive and more transparent. Taken together, they shift the information advantage from big dealers to end users, and could ultimately weaken the big-bank stranglehold.

This is a welcome development. Unregulated credit-default swaps sold by American International Group Inc. helped aggravate the crisis that followed the 2008 collapse of Lehman Brothers Holdings Inc. and forced the U.S. to rescue AIG.

Some observers think the CFTC buckled to the big-bank lobby. True, the agency weakened a proposal championed by its chairman, Gary Gensler, a former Goldman Sachs Group Inc. executive. He wanted to force buyers (Caterpillar Inc., say, buying a swap to protect itself against foreign currency movements) to get price quotes from a minimum of five dealers -- part of a campaign to break the dominance of the big players (Goldman, JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp. and Morgan Stanley). The Big Five control more than 90 percent of the market.

The final rules instead say buyers must seek only two quotes (three after a phase-in period, possibly starting in October 2014) on swap-execution facilities. Gensler agreed to the compromise after failing to persuade other commissioners -- two Republicans and one Democrat -- that five quotes were needed.

To be sure, Gensler was outmaneuvered. The big banks lobbied hard against the five-quote requirement. They argued that it would increase trading costs and reduce liquidity, which in this case means the ability to trade without moving prices a lot in either direction.

Here's my take: Big, global companies that use derivatives to hedge weren't on board, even though Gensler ostensibly was acting on their behalf. They said they might as well advertise their strategies in newspapers if they were forced to get five price quotes. In addition, the dealers that won their business would be at a disadvantage when it came time to hedge their swaps positions, since four rivals would know what cards they held.

Notwithstanding the loss of the five-quote rule, derivatives trading is about to go through seismic changes. JPMorgan seems to agree. In February, the bank said the new rules may cost it as much as $2 billion in revenue.

Today, most trades are done bilaterally -- one dealer calls another on the phone and negotiates prices and terms. There is no central facility on which to conduct trades, no consolidated tape on which to display post-trade prices, no clearinghouse to process and guarantee trades, and no minimum collateral requirements.

Dodd-Frank changes all that. The law requires most swaps to trade on so-called swap-execution facilities, essentially electronic platforms, or on existing commodities exchanges. Buyers and sellers will interact with multiple participants, not just a single dealer holding all the pricing information. A majority of swaps will be centrally processed and guaranteed by clearinghouses. Most trades will require the posting of collateral, which will change with the value of the underlying instrument.

Numerous companies, including Tradeweb LLC, Icap Plc and GFI Group Inc., are setting up swap-execution facilities, as is Bloomberg LP, the parent company of Bloomberg News. (Bloomberg has filed a lawsuit challenging a separate CFTC rule that the company said will harm its plans.)

The CFTC, in an earlier action that will heighten competitiveness, required clearinghouses to grant membership to trading firms with as little as $50 million in capital. This further opens access to the derivatives club beyond the big banks, which also dominate the clearinghouses that collect collateral and guarantee against buyer or seller defaults.

The loss of the five-quote rule, while a disappointment to reformers, won't dilute any of this.

(Paula Dwyer is a member of the Bloomberg View editorial board. Follow her on Twitter.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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