Federal regulators next week are set to propose new rules for trading over-the-counter derivatives, part of an effort to bring the $450 trillion market under government control for the first time, and shifting the balance of power between centralized exchanges and the world's largest financial institutions.
Congress tasked the Commodity Futures Trading Commission with shedding light on the opaque derivatives markets and bringing the majority of market activity -- possibly 80 or 90 percent -- into clearinghouses and centralized trading facilities. At stake is which market participants will profit and the cost of the new rules. Derivatives, financial contracts whose value is based on the price of an underlying asset such as a commodity, interest rate or currency, have been wildly profitable for Wall Street in recent years. The five largest U.S. dealers reaped an estimated $28 billion in 2009, according to an analysis by Bloomberg News.
The CFTC has received thousands of comments on its 30 separate rulemakings ordered by last summer's Dodd-Frank financial regulatory overhaul, with everyone from J.P. Morgan Chase and the Chicago Mercantile Exchange to the Air Transport Association and Cargill weighing in on requirements for registration, reporting, margin, capital, ownership of centralized institutions and preventing conflicts of interest. Big corporations and House Republicans want to preserve the ability to innovate, which caused OTC derivatives to explode in volume over the last two decades. Consumer advocates want the commission to open up the complex market to avoid a repeat of the 2008 financial crisis, when uncertainty about which institutions were exposed to losses caused capital markets to freeze up and threatened a chain reaction of bank failures. Big commercial interests want to avoid becoming subject to requirements aimed at derivatives dealers and startup trading platforms aim to compete with the established dealers.
"The crisis reminded us all how vulnerable we are to the risks that can build up in the financial system. ... Tens of millions of Americans were harmed," CFTC Chairman Gary Gensler said in an interview after a recent commission meeting. "If we can bring greater light into this dark market, that will help lower the risk."
The commission is proposing new rules almost exactly a decade after Congress blocked it from regulating OTC derivatives in the Commodity Futures Modernization Act of 2000. Futures and OTC derivatives are similar financial contracts, but derivatives have been privately negotiated between two institutions rather than trading on an exchange with terms and prices that everyone can see. The current regulatory effort could transform the derivatives markets into quasi-futures markets, which are closely regulated and whose lobbyists have argued for years that big banks unfairly escape regulation and its associated costs through OTC derivatives.
"It's very dramatic," said Michael Greenberger, a law professor at the University of Maryland and former CFTC official. "The banks are going to take a hit on this, there's no two ways about it. When you drive the economy into the ground and then you are rescued 100 cents on the dollar by the American taxpayer -- who is jobless, pension short and in terrible housing distress -- there's a price that's got to be paid for economic stability."
The high stakes came into sharp relief recently, when the CFTC discovered that several comment letters on clearinghouse ownership limits had been forged. Moreover, the five members of the commission have gone public with their policy disagreements, issuing statements about their concerns and the several dissenting votes cast by the two Republican commissioners.
The agency's final interpretation of Dodd-Frank could range from pushing trading almost entirely onto regulated exchanges to letting dominant market institutions continue to reap large profits with minimal regulatory interference. While the law calls for new derivatives rules to take effect by July 2011, Wall Street analysts expect full implementation to be phased in over the next two or three years because of the market's large volume and number of new institutions to be created.
"There's a lot of nervousness and hesitancy in the market. People are wondering how the rules will affect the way they conduct their business and what might happen to the transactions that they are accustomed to doing," said John Damgard, president of the Futures Industry Association, whose members include futures brokers as well as trading firms, exchanges and clearinghouses.
As regulators push derivatives markets to look more like futures markets, the big derivatives dealers are seeking to make money elsewhere in the system, said Mark Williams, a Boston University lecturer specializing in risk management. "The OTC market has been too profitable for banks for too long for them to just walk away," he said. "You're going to see margins decline, but you're going to see banks expand the products they're going to offer, and try to capture profit along the value chain."
In a clearinghouse system, every member reports its trades and must put cash into an account to cover potential losses. If those potential losses deepen, the clearinghouse orders firms to put up additional cash and can reassign the trades of any member who goes bankrupt. By pushing the majority of derivatives deals onto clearinghouses, policy makers aim to give investors greater certainty that in the event of a future crisis, no single institution's financial difficulties will cause a chain reaction of failures -- so-called systemic risk.
"Clearing is one of the tools you can use to produce a sounder, more stable environment that people have more confidence operating in," said Garry O'Connor, chief executive of International Derivatives Clearing Group, a swaps clearinghouse that launched in the wake of the financial crisis.
At their Dec. 16 meeting, commissioners plan to vote to begin the public comment process for some of the most high-profile rulemakings, the eighth in a series of proposals:
- Requirements for swap execution facilities (SEFs), new institutions created by Dodd-Frank for the trading of swaps and other OTC derivatives.
- Risk management rules for clearinghouses and business conduct rules for swap market participants.
- Position limits aimed at preventing manipulation of the derivatives and commodities markets.
Gensler has said that as many as 40 institutions may apply to become SEFs in addition to the 16 existing futures exchanges, and up to 200 firms could be considered swap dealers who must register with the commission. Prospective derivatives clearinghouses and exchanges stand to gain -- or lose -- much in the rulemaking process, especially when it comes to limits on ownership and governance. For instance, a group of derivatives dealers including Goldman Sachs owns part of Tradeweb, a system seeking approval as a SEF.
Other important open questions include how much capital firms will have to set aside to cover potential losses in their derivatives portfolios, conflict of interest and facility ownership rules, regulatory treatment of commercial participants in derivatives markets and whether large energy and agricultural companies might be considered dealers and subject to higher regulatory scrutiny.
"Derivatives provide very important risk management services to a growing audience of businesses that want to manage their risks," the FIA’s Damgard said. "To the extent it's going to be more expensive to trade these products, some people are going to say it's no longer worth it. We may see business going away in terms of moving to other jurisdictions or fewer people being willing to pay more for the kind of protection they've had in the past."