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February 22, 2010

Cover Story: The OTC Derivatives Clearing Debate Heats Up

Forced Clearing Needed, Some Say in Congress. But what will be its effect?

By Gregory Bresiger

Here comes a new era in over-the-counter derivatives clearing.

It will be an era of heightened regulation, in which swaps dealers could lose power to exchanges, clearinghouses and clearing counterparty systems.

A key committee of Congress recently passed a controversial OTC derivatives bill, HR 3795, with the support of the Obama administration. It requires that OTC derivatives swap transactions go through a clearinghouse, although numerous details of how the measure would be applied and which swaps would be exempted are unclear.


See Sidebars:

OTC Derivative Clearing, a Different Business

A Reform Too Far

HR 3795 New Clearing Requirements


"We think this is very important," said Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission.

The intent of the proposed new measure, lawmakers say, is to use clearinghouses to prevent a repeat of last year's market meltdown in the $1 trillion OTC derivatives business.

HR 3795 advocates say market woes were caused by OTC derivatives swap dealers who didn't use clearinghouses to process trades. The dealers, the bill's supporters say, couldn't properly quantify these complex trades. They ended up needing government bailouts.

But the ultimate effect of HR 3795 could be decided by regulators. The bill-should it become law-gives broad authority to the Securities and Exchange Commission and the CFTC, the two agencies that would translate it into rules and regulations.

If required clearing survives the coming legislative battles and becomes law, then the bilateral swaps dealer-to-dealer model would lose ground. By contrast, clearinghouses and exchanges employing the clearing-counterparty system would be the winners. That model is viewed by many lawmakers as safer and clearer than the bilateral system, which has been under attack in and out of Congress.

"The failure to properly measure and collateralize the risks of OTC derivatives had dire consequences," said Terrence Duffy, executive chairman of the Chicago Mercantile Exchange Group (CME), in testimony to Congress earlier this year. CME is preparing to clear standardized credit default swaps in December.

Obviously, the bill is aimed at major swap dealers, who are viewed as part of last year's problem. What, then, is a "major" swap participant?

The bill says a major swap participant is defined "as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose position creates such significant exposure to others that it requires monitoring."

CME's Duffy, a strong proponent of centralized clearing, nevertheless doesn't favor mandating it, even though that would appear to benefit an exchange like his. Duffy told lawmakers his position is not inconsistent. Mandated clearing, he contends, would have an unexpected outcome.

"If the OTC dealers do not embrace clearing, they can easily transact in another jurisdiction and cause significant damage to a valuable domestic industry," Duffy said.

Despite the threat of losing OTC derivatives business, HR 3795 advocates say the bill would require all standardized OTC products to go through clearinghouses and transparent trading venues "for the first time ever," according to a spokesman for the U.S. House of Representatives Financial Services Committee.

HR 3795, "The Over the Counter Derivatives Act of 2009, " stipulates that these OTC derivatives transactions must be cleared (see sidebar "The Bill").

Which swaps are covered? Here is the key issue in the debate over which piece of the OTC derivatives market should be cleared and which can continue to use the dealer-to-dealer model. The bill, in its working format as CQ&D was going to press, gives the SEC and CFTC broad authority to make these decisions.

For instance, the regulator could require clearing in the case of any transaction that the SEC determines is in "the public interest." The public interest, according to HR 3795, will require clearing in the case "of significant outstanding notional exposures, trading liquidity and adequate pricing data."

Other factors determining if a swap must go through clearing include the "impact on the mitigation of systemic risk, taking into account the size of the market for such contract," according to the bill. Those exempted from these clearing requirements must report transactions to a swap repository or directly to the SEC.

The bill is being put together-many amendments can be added as the bill goes through the legislative process-in coordination with Treasury Department officials.

The committee vote on HR 3795 in November was 43-26; it basically passed along partisan lines. HR 3795, which contains a package of financial service regulatory reforms, should be ready for a vote in the full House of Representatives by "early December," according to a spokesman for the committee's Democratic majority.

The bill has its critics in and out of Congress. They believe that mandating clearing for many OTC derivatives products would hurt the trading and processing of these trades.

"I am opposed to clearing mandates. Mandates are the wrong way to manage counterparty risk," said Craig Pirrong, a professor of finance at the Bauer College of Business at the University of Houston.

Pirrong said that the current dealer model, with both parties heavily collateralized, is "viable" and worked well in last year's market meltdown. Mandated clearing will also hurt the OTC business, he added.

That's a sentiment shared by those on the House Financial Services Committee who voted against HR 3795 (see sidebar "The Bill").

"The committee has heard from companies that use derivatives to manage risk that the Democrats' legislation will drive up costs," said Rep. Spencer Bachus, R-Al., the ranking minority member of the committee. Bachus argues that the bill, by raising regulatory costs, would result in "government overreach and would kill jobs."

However, a spokesman for the committee's majority Democrats argues that an OTC derivatives clearing mandate is needed to protect the taxpayers.

"They shouldn't have to take responsibility ever again for derivative trades that nobody knows about and that leave major counterparties hopelessly exposed," said committee spokesman Steven Adamske. Adamske also dismissed Republican objections.

"To now argue, after what we went through the last year, that we do not need heightened regulation is one of the most irresponsible statements I have ever heard," Adamske said.

The majority of the committee followed the lead of the Obama administration. This past spring, Treasury Secretary Timothy Geithner, in a letter to Congress, called for "all standardized OTC derivatives" to be cleared "though regulated central counterparties."

But HR 3795, an approximately 190-page bill, dances around one issue: What is a standardized and what is a customized OTC derivative?

"Who the hell knows?" said the University of Houston's Pirrong.

"The problem is that a bunch of lawyers writing this bill will decide, and many of these people have previously never even heard of derivatives," Pirrong said.

HR 3795 is sponsored by Rep. Barney Frank, D-Mass., the Financial Services Committee chairman. In a letter to the SEC and CFTC, he said the "responsibility" for deciding exemptions will be "with the regulator."

But although lawmakers are looking to regulators to hammer out the details, they obviously believe more OTC derivative transactions should go through clearing. Why are they pushing for more use of central counterparties?

A CCP would take on much of the counterparty risk now handled by the dealers, says an industry analyst.

"They will provide more position reports among counterparties that can be more easily audited," said Stephen Bruel, a TowerGroup analyst. "And also from a pricing perspective, any CCP will have to mark each position at the end of the day."

Bruel added that the regulators don't care which CCP attracts the liquidity. Whether it is an exchange such as CME or the IntercontinentalExchange or a clearinghouse doesn't matter, "as long as there is a CCP standing in the middle," he said.

Regulators now like CCPs, he explained. However, Bruel contends that opting for CCPs won't end all counterparty risk.

"It will not necessarily eliminate it. It just moves it around a bit," he said. It will add more transparency, Bruel says, which is an important issue for regulators and lawmakers.

Yet some market observers, in a recent report, say OTC derivative clients could also be losers in any OTC derivatives reform that hurt the customized contracts.

"The risk here is that there are valid reasons why many participants in the OTC market do not want cleared products. Corporates, in particular, seem well suited to the status quo." Here interdealer positions "are heavily collateralized, with client positions subject to negotiation," said a Bank of America report, "OTC Reform-Evolution or Revolution?"

The issue for dealers is how standard and customized OTC derivatives will be treated and how will they be defined, according to the report. But some dealers, lawmakers say, might try to avoid clearing by claiming their derivative contract is unique and isn't covered by new clearing standards.

Geithner, in his letter, wrote that the reform that will be signed into law would also ensure that customized derivatives aren't used solely as a way of avoiding a CCP.

How can one be distinguished from the other?

The standard, Geithner wrote, will be "if an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is a standardized contract that requires clearing."

Yet some dealers are privately worried that their customized products will be hurt. None would speak on the record to CQ&D. Yet one official at a swap dealer argues for the dealer system.

"We have very heavy bilateral collateralization. Therefore, the riskiest OTC derivatives markets benefit from our practices," he said. Dealers also privately tell CQ&D, they need to retain flexibility to create unique derivative products that are subject to the clearing process.

Lloyd Blankfein, CEO of Goldman Sachs, notes that swaps dealers have offered these exotic instruments as a result "of client demand for individually tailored solutions."

Blankfein, in a recent speech, contended that the non-standardized derivatives performed well in the market meltdown.

"They increased the ability of market participants to diversify their credit exposure in companies-some that were financially strained or ultimately went bankrupt-by swapping default risk with others. In that vein, these instruments represent an important economic and social purpose," Blankfein said.

Interestingly, Blankfein favors central clearing for standard derivatives, arguing that a clearinghouse would reduce bilateral risk and increase transparency. Nevertheless, Blankfein, in his recent speech, said the trick of formulating any new rules that will work effectively is to strike the right balance between innovation and regulatory reform.

"The debate gets harder when defining what should be traded on and off an exchange," the Goldman Sachs executive said (see sidebar, "A Reform Too Far").

Non-standard OTC derivatives should have greater capital requirements, Blankfein said. But regulatory trading and clearing reforms should not kill the good aspects of this business.

But will Congress, in the final version of HR 3795, direct regulators to take action that will hurt dealers designing these unique products? An industry analyst is doubtful.

"I don't think so," predicts Mayiz Habbal, a securities industry analyst with Celent. Habbal said swaps dealers often have done a better job than exchanges.

"The OTC market," says the Bank of America report, "has been historically the most obvious source of innovation in financial markets. Exchanges have overall been relatively unsuccessful in leading product innovation, while the OTC market has seen contracts like interest rate swaps and CDS take off in pretty spectacular fashion."

Still, HR 3795, depending on how it is applied should it pass, could result in major changes in the OTC derivatives business. Exchanges and clearinghouses could win. Dealers could lose.

"They're really hurting the dealers," an official for a big dealer, who didn't want to be quoted by name. "This will make it more expensive to do this kind of business. It will make people think twice about standardized and customized derivative contracts."

It could be a legal nightmare, Pirrong says. He asserts that these new rules will constitute a new jobs program for lawyers. Lawyers, he says, will come to dominate the derivatives trading and clearing business. "And that will certainly drive up costs for everyone," he said.

Celent's Habbal doesn't believe the customized OTC derivatives will be required to go through clearing. He thinks that the actual effect of new OTC derivatives rules will be diluted. His reasons?

People are less panicky than they were in 2008 and are less likely to demand radical changes, he said. The regulators who will write the rules "have a better understanding of the business than Congress."

And regulators, he added, understand that the dealer-to-dealer system works. "There's no way," Habbal said," they're going to hurt that system."



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