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Reforming Over-The-Counter Derivatives

Legislators want to reform derivatives trading. The market may beat them to it.

Intent on preventing a repeat of the financial crisis, Congress and the Obama administration have been scrutinizing over-the-counter derivatives — the instruments that nearly bankrupted insurance firm American International Group. Washington lawmakers are, for instance, debating reforms to the opaque U.S. OTC derivatives market that would include the use of central clearinghouses to reduce systemic risk. Clearinghouses that net trades among multiple dealers have been shown to reduce the risk of, say, a Lehman Brothers Holdings’ defaulting on its derivatives commitments and thereby causing losses to cascade through the market.

Meanwhile, in financial firms’ back offices, there is a flurry of activity as derivatives market participants bow voluntarily to the need for greater transparency, perhaps through the very kind of clearinghouses Congress may mandate.

“There is profound concern about counterparty risk and transparency,” says Gary DeWaal, general counsel and head of legal and compliance at Newedge USA, a broker-dealer joint venture between Société Générale and Calyon Financial. “Any legislation may be irrelevant because the private sector is moving in the direction of centralized clearing. The market is doing it independently of whatever Congress wants.”

Even those firms fortunate (or well connected) enough to collect in full on credit default swaps that were backed by AIG as the subprime mortgage market imploded now agree that reforms are badly needed in the derivatives market. Listen to Goldman, Sachs & Co. CEO Lloyd Blankfein’s testimony in January before the Financial Crisis Inquiry Commission: “A central clearinghouse with strong operational and financial integrity will reduce bilateral credit risk, increase liquidity and enhance the level of transparency through enforced margin requirements and verified and recorded trades. This will do more to enhance price discovery and reduce systemic risk than perhaps any specific rule or regulation.”

Clearinghouses, which are nothing new for markets like exchange-traded futures, options and equities, are being extended in fits and starts to the OTC derivatives market. Among other initiatives: New York–based ICE Clear U.S. and London-based ICE Clear Europe (both owned by IntercontinentalExchange) and Chicago’s CME Group have all in the past year launched clearinghouses that can handle credit default swaps. And last year 15 large derivatives dealers, including Bank of America Merrill Lynch, JPMorgan Chase & Co. and Morgan Stanley & Co., agreed to clear the majority of new interest rate and credit default swap index trades through such facilities.

The Depository Trust & Clearing Corp., a clearinghouse and depository formed to address Wall Street’s 1970s paperwork crisis, backs what it regards as a crucial refinement to the government’s proposal that all OTC derivatives trades be cleared through a central counterparty or registered in a central repository. Peter Axilrod, managing director of the DTCC (and its former risk manager), asserts that all OTC trades, whether centrally cleared or not, should also be reported to a single database. Multiple databases, or repositories, “would fragment that responsibility and create the risk of inadequate oversight of derivatives markets at times of crisis,” he says.

DTCC launched its own central repository in 2006, and today more than 95 percent of all OTC credit derivatives are recorded in its database and matched by MarkitSERV, an electronic matching and confirmation platform. Axilrod insists that “timely information and marketwide exposure of the major market participants” would help avoid future bank bailouts.

Clearinghouses, however, are not a foolproof solution. As Raf Pritchard, CEO for North America of  TriOptima, which aims to reduce risk by reconciling transactions between counterparties, notes, “There will always be trades outside clearing as the contracts can’t all be standardized.”

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