UPDATE 1-Derivatives clearing stymied by rules-SDMA

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NEW YORK, June 15 (Reuters) - Efforts to expand central clearing in the $450 trillion privately traded derivatives markets are being impeded by rules that reinforce the dominant role of large dealers in the markets, at the expense of new entrants, a trade association said on Tuesday.

U.S. lawmakers are expected to approve this week a financial reform bill that will require most contracts to be routed through clearinghouses, which guarantee the trades, in order to reduce risk associated with a counterparty failure.

However, there are still a number of issues of "access, fair dealing and systemic risk mitigation" that need to be addressed in order for central clearing to be successful, the Swaps and Derivatives Markets Association said in a report sent to the New York Federal Reserve Bank.

The SDMA comprises a group of brokers and fund managers active in the derivatives markets and is pushing for better access to central clearing and electronic trading of the contracts.

The IntercontinentalExchange Inc (ICE.N) and the CME Group (CME.O) are the only two exchanges to have begun clearing credit default swaps in the United States. Buyside participation has been limited by a small product choice as well as concerns about contract details and the protection of collateral backing the positions.

One factor impeding broader adoption of clearing for credit default swaps and interest rates swaps is the rules set by clearinghouses that effectively limit membership to the largest firms, by linking clearing membership to market making and imposing arbitrary capital requirements, the SDMA said.

This, in effect, restricts membership to the same small group of dealers that currently dominate derivatives trading, the association said.

"The linkage of clearing to the function of a dealer is a red herring designed to exclude independent participants," it said.

Requirements that a dealer enter a trade into central clearing on behalf of clients also limits access because it blocks clients from being able to enter trades anonymously, increases the risk of front running, and allows dealers to act as gatekeepers to clearing institutions, the SDMA said.

"Open clearing will reduce transaction costs, increase transparency and create a safer derivative marketplace," it said.

Legal constraints, including agreements that give dealers control over deciding obligations for trading losses and licensing restrictions on trading products including indexes, are also impeding open access to clearing, the SDMA said.

Meanwhile laws that will allow industrial companies, also known as end-users, to be exempt from central clearing will leave substantial systemic risks from the contracts, it said.

"End users argue for choice in managing their risks, either through clearing houses, if available, or through bilateral contracts," the SDMA said. "However this is a self-interested view that ignores the risk to the entire market."

Exempting trades will reduce transparency, increase the cost of the contracts, and make it more difficult for regulators to gauge the amount of risk in the markets, the SDMA said.

Other factors impeding the expansion of clearing of credit default swaps are arguments that a contract must have a minimum trading volume to be eligible, the SDMA said.

"Volume works as a proxy for liquidity in some financial products but is a poor proxy for accurate pricing in the corporate credit market," it said. For example, while many five-year contracts become less liquid as they mature, they are still able to be accurately priced by using the yield curve of the contract, the SDMA said.

(Reporting by Karen Brettell; Editing by Andrew Hay)