Banks Seek Role in Bid to Overhaul Derivatives

The battle lines are being drawn in the derivatives market, as Wall Street tries to pre-empt new laws that could drain a big source of banks' profits.

Source: Source: WSJ | Published on June 1, 2009

A group of banks and money managers will next week present a plan designed to help fend off some rules proposed by the Obama administration, which wants to reform trading practices in the market for over-the-counter derivatives.

The banks are treading a fine line. They are being careful not to publicly oppose any rules and know that more regulation is inevitable. But at the same time they are seeking to stymie legislation that could seriously hurt their ability to generate fees. The banks plan to release a letter to the Federal Reserve Bank of New York and other U.S. and overseas regulators in coming days, according to people familiar with the matter.

Earlier this month, the U.S. proposed giving the Securities and Exchange Commission and the Commodity Futures Trading Commission authority to mandate centralized clearing of certain derivatives, impose new trade-reporting requirements, and force trading of "standardized" contracts onto exchanges or electronic platforms that will make prices more transparent.

Wall Street banks with large derivative-trading businesses have been outwardly supportive of greater regulatory oversight of the $684 trillion market. But behind the scenes, there has been hand-wringing over the details of certain proposals and discussions about how the industry can help shape the rules. Many bankers are against mandatory exchange-trading and real-time price reporting of trades.

Potentially billions of dollars in revenue is at stake. An effort earlier this decade to improve transparency in the corporate-bond market ended up cutting bank fees by more than $1 billion in a year, according to some studies.

In the letter, expected to be released next week, the banks will reiterate a commitment to meet the government's goal of transparency.

The industry will detail plans to expand central clearing of credit-default swaps to investment funds and other market participants. It also will propose that customized credit derivatives like those that nearly brought down American International Group Inc. be reported to a trade-information warehouse run by Depository Trust & Clearing Corp. On Thursday, DTCC moved to have its warehouse overseen by the Federal Reserve as it seeks to align itself with regulators' goals.

So far, some regulators and politicians are holding a hard line, insisting that radical changes are needed to avoid a repeat of last year's market panic when large financial firms neared collapse and no one knew how linked they were to others through derivatives. The reforms also mean that "the days of conducting standardized derivative trades over the phone will soon be over," said one senior administration official.

The industry's letter is unlikely to address whether some trades should go on a central platform and be reported publicly in a similar manner to trades in securities like corporate bonds.

For credit-default swaps, information about intra-day trades and prices has long been controlled by a handful of large banks that handle most trades and earn bigger profits from every transaction they facilitate if prices aren't easily accessible.

For example, credit-default swaps tied to bonds of companies such as General Electric Capital and Goldman Sachs typically have a pricing gap of 0.1 percentage point between the bid and offer price. That translates into a $40,000 margin for every $10 million in debt insured for five years. Greater price transparency could narrow that gap, lowering costs for buyers and sellers but reducing fees for banks.

One price-reporting model being considered for the market is a system akin to Trace, a system for corporate bonds. After Trace was implemented in 2002, the gap between bid and offer prices halved, cutting trading profits for banks. Many bankers still lament that the transparency made traders less willing to take big positions in corporate bonds and encouraged more trading in the opaque credit-default swap market.

Still, the lack of more detailed information in the credit-default swap market has created "a lot of hyperbole and a perception that the market is a lot bigger and liquid than it really is," says Mark Alexandridis, managing director of First Principles Capital Management LLC, a money manager in New York.

The limits of the current system were at play last September, when panic encircled Morgan Stanley as investors saw the cost of its credit-default swaps surging. But aside from indicative bid and offer price "quotes" sent by Wall Street dealers to their clients, few investors knew what trades had actually taken place in Morgan Stanley swaps, and some cautious clients chose to pull away.

A Morgan Stanley spokeswoman declined to comment.

Wall Street currently reports most credit-default swap trades to the DTCC, which releases data to the public weekly. Earlier this year, financial information provider Markit began publishing end-of-day prices on credit-default swaps tied to about 400 bonds on its Web site. Regulators, however, want to see more.