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Why Derivatives Reform Really Matters

Derivatives reform is a big deal, but for reasons that are much more pragmatic than populist.

Rich Blake

Lawmakers look after their constituents in a variety ways.

Laws have been passed banning pedestrians from darting across thoroughfares at undesignated junctures. Laws have been passed forcing Taco Bell to display prominently the calorie count in a chalupa.

Soon, a law could be passed requiring Wall Street banks to standardize and centrally clear derivatives trades. Wall Street isn't necessarily happy about it.

On Thursday, President Obama, speaking in New York City at Cooper Union, about one mile north of Wall Street, made what amounts to his "closing argument" for reform. Quoting from a 1933 Time magazine article about Wall Street's aversion to the creation of the FDIC, Obama demonstrated to clever effect how financial legislation can achieve common sense goals without ruining the banking industry.

Derivatives reform is a big deal, but for reasons that are much more pragmatic than populist.

In a conference call the other day, Goldman Sachs CFO David Viniar mentioned that the bank supported the new derivatives measures being proposed, that standardization and central clearing made the industry safer and Goldman more competitive.

To his credit, Viniar must have just gotten the memo explaining that the OTC derivatives rules overhauling was actually happening, that millions of dollars in lobbying efforts to influence the outcome of the debate or weaken or kill the proposal, had been in vain, and that it was time to throw in the towel.

But why would the industry ever fight standardized, central (third party) clearing of derivatives in the first place? After all, what's so terrible about having a third party in the mix, and a consortium of parties all putting up some baseline insurance/collateral so in the event that a counterparty (let’s say, AIG or Lehman Brothers) croaks there is at least an orderly system for making owed parties as whole as possible and cushioning the blow without billions of taxpayer dollars having to be tapped. Opposing centralized clearing is the same as opposing the mitigation of "counterparty risk," or "systemic risk," concepts underscored by the AIG debacle. Why would Wall Street oppose addressing the very issues at the heart of the next possible crisis?

To get to the core of the derivatives regulation debate, let’s take a look at the interest rate swaps market, one of the oldest and most standardized of all OTC markets.

On a notional basis, this market is more utterly humongous than most ordinary people realize or could ever get their head around.

According to the Bank for International Settlement, the total outstanding notional value of global OTC interest rate swaps contracts is $342 trillion. That’s all theoretical, on paper, but nevertheless reflects a vast amount of underlying assets being hedged over time horizons spanning up to 50 years out.

Roughly 40 percent of this market already involves centralized clearing, according to LCH.Clearnet, a clearinghouse which clears OTC interest rates swaps.

So what about the other 60 percent? What is their aversion to central clearing?

Turns out, the interdealer market prefers and embraces central clearing while the buy side community, money managers, including hedge funds, has historically not embraced it. After Lehman went belly up, though, the sobering reality of counterparty risk has apparently done more to encourage centralized clearing of interest rate swaps faster than any lawmaker in the land could craft a speech about reining in Wall Street. According to LCH.Clearnet, the buy side is now warming up to the idea of doing more rate swap trades that involve a centralized clearing house, because it’s safer, in much the same way most motorists embrace the rule requiring them to purchase auto insurance.

Up until a few weeks ago the big OTC market controlling banks were twisting arms to prevent centralized clearing of OTC derivatives from becoming law.

But now this particular fight appears over. So be it; centralized clearing is a reasonable requirement and it’s for Wall Street’s own good. If funds and banks grumble that having to put up more money to do trades, more skin in the game, and having to allow in more sunlight (via a neutral third party being even involved) cramps their style or hurts their ability to do their thing or puts them at a competitive disadvantage, then to that I would say yes perhaps but look what happened to AIG.

How can averting another near financial Armegddon not be a shared, standardized, centralized goal? I hate it that when I go to order a Burger King feast I am hit in the face with the near 1,000 calories involved in my two Whopper Jr parlay; but damn it, I must begrudgingly admit it keeps me from ordering my usual three.

As the President basically said on Thursday, when it comes to the case for derivatives reform, specifically centralized clearing, we need no further proof then the crisis we just went though.

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