On March 14, 2010 Senator Dodd and the Senate Banking Committee released their latest Financial Reform Bill. Broadly speaking, the fewhundred pages of this bill dedicated to reforming the OTC derivatives market showed few major changes from either the previous Senate bill release in November 2009 or the House Bill passed in December 2009. This does not come as much of a surprise as the major tenets of OTC derivative reform appear to be decided – standardized products will be traded through a registered platform and centrally cleared, dealers will register with the SEC and/or CFTC based on the products they trade and all OTC derivatives trades not cleared will be reported to a trade repository and subject to margin requirements. The devil however, continues to be in the details.
One point of contention that will be worth watching over the next few weeks, as the markup process begins and Sens. Reed and Gregg make public their amendment focused on OTC derivatives reform, is the definition of Major Swap Participant. A lot hinges on how that three word term is defined, most importantly which firms must adhere to execution and clearing mandates and which will be exempt. Both the House and Senate bills tell us that both parties to any given trade must be either Dealers or Major Swap Participants for the trade to fall under the execution and clearing mandate. The major dealers will most certainly be regulated, but for larger hedge funds and major end user firms who’s role in the market is up for debate, avoiding the mandate could save them millions while allowing them to keep control over what they execute in the open and what they centrally clear.
The root of this debate is systemic risk. Those firms deemed systemically important should be more heavily scrutinized then those that are not. While the distinction might be obvious for some (think JPMorganChase or Citigroup) it is less obvious for others (Citadel or Bluemountain Capital, for example). If one of the aforementioned dealers was to file bankruptcy the impacts on the global economy would be massive. Global markets would scramble, retail investors would withdraw money and uncertainty would hang over who might be next. We’ve seen this happen recently, so the situation requires no further explanation. If a major hedge fund was to file bankruptcy however, the results are much less clear.
Investors in that fund would lose money. Many people within the firm would lose their jobs. Other market participants would also lose money based on their counterparty exposure to the hedge fund. If the firm happened to be a more traditional asset manager, one managing money for “regular” people, even more people would get hurt as retirements accounts could get wiped out. Despite all of the this potential loss and the growing interconnectedness of these “near banks” with major dealers, how systemically important they really are is unclear.
Now back to Washington. The Senate Bill defines Major Swap Participants as those firms “whose failure to perform under the terms of its swaps would cause significant credit losses to its swap counterparties”. That language focuses in on the trading partners of the firm in question, not the broader economy. It also speaks in certainties; “would” cause losses. The House Bill takes the opposite approach. Major Swap Participants include firms “whose outstanding swaps create substantial net counterparty exposure among the aggregate of its counterparties that could expose those counterparties to significant credit losses.” The aggregate exposure can be read more specifically as the broader economy, and hence creating systemic risk. Use of the word “could” broadens the scope of the statement further, proposing that any firm that has the potential to cause systemic risk should fall under the mandate’s purview. I’m splitting hairs over subtle wording differences, but the more I focus on the legislative process the more I understand that’s how it works.
Despite all of the hair splitting over legislative language, it will ultimately be the CFTC and SEC who decide which firms fall where. Beyond the above criteria, firms with a “substantial net position” also will fall in the category of Major Swap Participant, and that number will come from the aforementioned regulators once the proposed bill is made law.
TABB Group is broadly for expanding the use of central clearing for those OTC derivative products deemed suitable; and the more electronic trading and automation the better for most any financial market. However, beyond those firms that show clear systemic importance mandates are less desirable than simply providing access to risk reduction and price discovery tools and allow natural market forces to work.
As for the legislative process, TABB Group believes that we will see something passed before the November election. If that does not happen, than financial reform very well may be DOA. If cooler heads prevail and the President signs the bill into law, regulators will spend 6-12 months writing rules in 2011 with final implementation coming in 2012 right as the Olympics get underway in London. Stay tuned – if this process was a triathlon we’ve only just gotten on our bikes.