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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

Also in this article

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").