Crisis could spark migration to regulated markets

Traders work on the floor of the New York Stock Exchange, September 18, 2008.

NEW YORK (Reuters) - The reconstruction of Wall Street is expected to boost derivatives exchanges as regulators push for transparency and shaken investors think twice about their trading partners.

Exchanges could benefit at the expense of the vast over-the-counter (OTC) market, where traders deal directly with each other and where major investment banks -- now either collapsed or badly shaken -- play a key role.

The risks of trading in the hidden OTC markets were laid bare last week after derivatives dealer Lehman Brothers LEHMQ.PK filed for bankruptcy, sending counterparties scrambling to re-hedge trades elsewhere.

Exchange operators, particularly CME Group Inc (CME.O), could capitalize on a migration to the light of regulated exchanges, where internal clearing houses assume the credit risk that one side of a trade might fail to honor their commitments.

"We may see this is the catalyst that pushes OTC trading on to exchanges," said Diego Perfumo, analyst at Equity Research Desk, a Connecticut-based advisory firm specializing in exchanges.

"It shows the regulators that this is the role model to adopt in the future when they look to fix the system."

This week, Lehman fell, Merrill Lynch MER.N agreed to be bought, and several financial stocks dove to multi-year lows in what is being characterized as Wall Street's most severe shake-up since the Great Depression.

As a life raft, central banks around the world poured hundreds of billions of dollars into global credit markets. Britain and the United States also banned short selling on some stocks.

Stock markets started to recover late Thursday and on Friday, but many expect the U.S. government -- having also bailed out giant insurer American International Group (AIG.N) this week -- to ramp up market regulation in order to stave off further crises.

Even Kenneth Lewis, the chief executive of Bank of America Corp (BAC.N) -- which will acquire Merrill -- called on federal regulators on Friday to heighten their oversight on investment banks.

"The regulators are going to squeeze the OTC business on to exchanges like a tube of toothpaste," said the president of Toronto-based Caldwell Investment Management, Brendan Caldwell, a Chicago Board Options Exchange seatholder.

"It's not the exchange-traded stuff that has caused this debacle, it's the unregulated OTC stuff."

EXCHANGES GAINING GROUND

OTC markets are attractive partly due to that lack of regulation. Institutions, retailers and brokers flock there to trade innovative and complex products, such as credit default swaps, which have exploded in popularity the last five years.

But even some OTC traders told Reuters more derivatives products would now gain traction on exchanges, which are slowly gaining ground.

Exchanges accounted for 18 percent of the value of the world derivative markets in 2006, up from 13 percent in 2000. The rest took place on OTC markets, according to the Bank of International Settlements.

As long as it is difficult to tell how risky it is dealing with investment banks in OTC markets, even more trades could move to exchanges, said Rick Redding, managing director of products and services at CME Group, the world's largest derivatives exchange.

"While it is painful for the marketplace going through these events, it does shine a light on the benefits of the clearing house. After the events unfold it tends to be good for exchanges," he said in an interview.

CME, which acquired NYMEX and its ClearPort clearing house last month, cleared more than 20 million contracts in each of the last four trading days. That easily eclipsed its 2008 daily average of 13.8 million contracts per day.

Analysts said CME rival IntercontinentalExchange (ICE.N) could also benefit from the financial turmoil. On Friday, the futures market operator became the exclusive venue for Russell contracts, which have seen a spike in volume this week.

Meanwhile, record option volumes were set on U.S. exchanges Wednesday, and then again on Thursday, according to the Options Clearing Corp.

"Transparency is the big issue," said Bud Haslett, director of options at institutional trading firm Miller Tayback. "There is a push now toward more exchange traded options because they are regulated more stringently."

That may partly explain the stability of CME shares over the last couple weeks, relative to other financial stocks. At $405, CME shares closed at their highest level in three months on Friday afternoon.

(Editing by Brad Dorfman)