NEW YORK (Reuters) - Efforts to move the $450 trillion privately traded derivative markets to central counterparties may be limited to certain contracts as clearinghouses balk at taking on the risk of hard-to-value transactions and dealers act to protect margins.
Central counterparties are key to efforts by the Obama administration to remove the risk that the failure of a large dealer will spark a chain of defaults, or that fears of losses on the contracts sparks a run on banks as happened with Bear Stearns and Lehman Brothers.
U.S. regulators are proposing that all "standardized" contracts be centrally cleared, but so far, it's unclear how that will be defined.
Clearinghouses, which assume the risks of the contracts and determine margins posted against them, may be unwilling to clear contracts they deem risky.
"If we're going to mutualize risk in a central clearing agency or body, we don't want to tax it where it becomes the Lehman of the future, we don't want it to become the entity that the government is going to have to prop up," said Ian Cuillerier, partner at law firm White & Case in New York.
Craig Donohue, the Chief Executive of CME Group (CME.O), the world's largest derivatives exchange, said this week that he wants the freedom to decline clearing contracts that don't have independent and liquid prices, even if they may be considered to have "standard" terms.
This may include some single name credit default swaps (CDSs), he said.
CDSs are used to insure against default or to speculate on an issuer's credit quality.
The contracts exploded in volumes in the credit boom from 2003 and 2007 and were used by companies including American International Group to take outsized exposure to risky assets, which led to it needing a series of government bailouts.
Proposals to mandate that all "standardized" derivatives be centrally cleared include the $400 trillion interest rate and foreign exchange markets, as well as contracts on equity and energy assets, though most attention is focused on CDSs.
InterncontinentalExchange Inc (ICE.N), which operates the only clearing house yet to clear CDSs, has cleared more than $1 trillion in notional volumes in index trades, and has said it will extend clearing to single name contracts.
Many of these trade infrequently, however, which raises complications over daily price and margining requirements.
CDSs can be more volatile than other derivatives as their value can rapidly change if a borrower is suddenly deemed near default, and in some cases defaults can occur before sufficient collateral payments can be made.
Dealers may also resist pushing too many trades to clearinghouses to protect their market share.
The absence of central clearing in derivatives has enabled a small group of large banks including JPMorgan (JPM.N), Goldman Sachs (GS.N) to dominate as investors sought highly rated trading parties that, until mid-2007, were viewed as having negligible default risk.
Banks have been accused of benefiting from opaque, non-public prices of derivatives as it makes it harder for clients to see comparable trades and allows them to charge higher trading fees.
"Financial institutions earn extraordinary profits from the lack of transparency in the marketplace and from the privileged role they play as credit intermediaries in almost all transactions," Ken Griffin, Chief Executive at hedge fund Citadel Investment Group, told lawmakers this week in testimony on derivatives regulation.
Citadel has a joint venture with the CME to clear CDSs, while ICE has a revenue sharing agreement with major dealers.
With central clearing, trading platforms and exchanges have the potential to match trades, and book them into central clearing, taking business away from banks, said Kevin McPartland, senior analyst at TABB Group in New York.
Inter-dealer brokers may also see opportunity. "If they could move their clients from that voice business that they do so much and onto the platform, it's almost like instant liquidity," he said.
Regulators are encouraging more electronic trading, but proposals stop short of any mandates. While some banks may fight transparency to protect margins, others may see opportunity, said McPartland.
"We're getting the smart response from a lot of market participants of trying to embrace the changes and figure out how to take advantage and profit in the new world, rather than trying to fight it," he said.