Dealer profits at stake in US derivatives debate

NEW YORK, March 25 Thu Mar 25, 2010 2:21pm EDT

NEW YORK, March 25 (Reuters) - U.S. senators are at an impasse on details of how to reform the $450 trillion privately traded derivatives market, and the final bill may determine how much market share, and profits, large dealers can retain in the lucrative markets.

The Senate Banking Committee last week approved a sweeping bill for financial reform, drafted by Democratic Chairman Christopher Dodd. For details, see [ID:nN14165412].

The derivatives component of the legislation, however, was considered a placeholder pending amendments from Senators Jack Reed and Judd Gregg. Reed, a Democrat, said on Friday that he and Gregg, a Republican, were unable to agree on details about exemptions in the bill.

A key question is how many trades are ultimately put into central clearinghouses, which may then be subject to electronic trading. This has the potential to narrow trade margins and shift market share away from dealers to newer players, including exchanges.

Revenues lost from dealers could be significant. Research and advisory firm TABB Group estimates the top 20 dealers generate around $40 billion annually from privately traded derivatives, excluding credit default swaps.

JPMorgan (JPM.N), one of the largest derivatives dealers, has said it generated a third of its overall investment banking profits from over-the-counter derivatives between 2006 and 2008, Moody's Investors Service said in a recent report.

The failure of senators to reach agreement, "significantly diminishes the prospects for OTC derivatives reform becoming law this year," analysts at Keefe, Bruyette & Woods said in a report.

The impasse gives dealers time "to take control of the process themselves and the Europeans to move closer to regulatory reform before the U.S. revisits next year," they said.

Central clearing, in which a central counterparty stands between trading partners and guarantees the trade, is viewed as key to reducing the risks from derivatives due to the maze of exposures of the contracts between large institutions that are considered critical to the financial system.

By removing counterparty risks from the contract, clearing has the potential to open up trading and brokerage of the products, allowing investors to bypass large dealers that currently act as intermediaries to all trades.

The Dodd bill calls for exchange trading of the contracts.

"The bill's requirement that centrally cleared OTC derivatives be exchange-traded will likely permanently impair the profitability of this business for dealers," Moody's said.

However, "because the dealers also recognize the threat of exchange-trading to their profits, the bill's linkage of central clearing to exchange trading could become an obstacle to such cooperation," they added. "To protect market-making and structuring spreads, the dealers could choose to reduce, as much as possible, the centrally cleared proportion of the market."

Companies that use derivatives to hedge against interest rate, currency, commodity and other risks are likely to win exemptions from clearing because they say that margin requirements would be too costly.

Defining which companies are hedging, as opposed to speculating with the contracts, however, may be difficult.

There is also debate over which companies will qualify as major swap participants and therefore are required to centrally clear all eligible contracts, and whether this would extend to large hedge funds or other speculators, in addition to dealers.

The Dodd bill defines a major swap participant as someone whose failure would cause large counterparty losses.

Meanwhile, the Commodity Futures Trading Commission and Securities and Exchange Commission, which will enforce the rules, may push for few exemptions.

CFTC Chairman Gary Gensler has said exemptions should be narrowly applied, and that all financial companies, including insurance companies and hedge funds, should be required to centrally clear eligible positions.

Gensler has further said that contracts that are not cleared should still be traded on electronic trading platforms to promote transparency and reduce trading costs. (Reporting by Karen Brettell; Editing by Kenneth Barry)

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