Wall Street's 'Derivatives Dealers Club' May Break Up

By Silla Brush


A U.S. regulatory proposal to broaden access to clearinghouses may help MF Global Holdings Ltd., Jefferies Group Inc. and dozens of smaller banks and brokers win entry to a market dominated by Wall Street's biggest banks. The Commodity Futures Trading Commission has proposed a rule that would require clearinghouses in the $583 trillion global swaps market to open membership to companies with at least $50 million in capital. ICE Trust LLC, the largest U.S. clearinghouse for credit default swaps, and LCH.Clearnet Group Ltd., the world's largest interest rate swaps clearinghouse, both require members to have at least $5 billion in capital. The CFTC rule, proposed in December as part of the Dodd-Frank financial-overhaul law, "would help break up the club" of derivatives dealer banks on Wall Street, said Robert Litan, vice president for research and policy at the Kauffman Foundation in Kansas City, Missouri. Litan, a deputy assistant attorney general in the Justice Department under the Clinton administration, wrote last year that a "derivatives dealers' club" controls clearinghouses, data providers and other parts of the market. For the smaller banks and brokers, becoming a clearing member instead of having to work through a third party would provide a greater opportunity to win part of the lucrative business of buying and selling derivatives. Goldman Sachs Group Inc. estimated that 25 percent to 35 percent of its revenue came from derivatives between 2006 and 2009, according to data the bank provided to the Financial Crisis Inquiry Commission, a panel appointed by Congress that investigated the 2008 crisis.

'Fair and Open'
 The new clearinghouse rule is part of efforts by the CFTC and the U.S. Securities and Exchange Commission to write new derivatives regulations under the Dodd-Frank law, after largely unregulated swaps helped fuel the 2008 credit crisis. Enacted by President Barack Obama in July, the law aims to reduce risk and increase transparency by having clearinghouses stand between buyers and sellers and guarantee trades. Gary Gensler, CFTC chairman, said in December that by allowing more companies to become clearing members, the rule would fulfill Dodd-Frank's aim of promoting "fair and open access" to clearinghouses for interest rate, credit and other types of swaps. Derivatives, including swaps, are financial contracts tied to currencies, bonds, equities or events, such as the default of a company. The Basel-based Bank for International Settlements estimated in 2010 that the global market for private, or over-the-counter, derivatives was $583 trillion.

Doubling Membership
Currently, clearinghouses have about a dozen members each. ICE Trust U.S., owned by Atlanta-based Intercontinental Exchange Inc., has 14 members, including Deutsche Bank AG, Goldman Sachs and JPMorgan Chase & Co., that clear credit default swaps. CME Group Inc. requires its 10 clearing members for credit default swaps to have at least $500 million in capital and its 12 members for interest rate swaps clearing to have at least $1 billion in net capital. By lowering the capital requirements, the CFTC proposal may "double or triple" the number of clearinghouse members, said Brian Yelvington, head of fixed-income strategy at Knight Capital Americas LP in Greenwich, Connecticut.  "I could see your realistic upper bound being in the 50 to 60 dealer range," Yelvington said in an interview. The increase would be less for credit default swaps, he said.
MF Global and Jefferies, both based in New York, and 21 other members of the Swaps and Derivatives Markets Association have been urging regulators over the last year to require more access to clearinghouses. Jamie Cawley, co-founder of the association, said having more members would lessen risk in clearinghouses and make the market more competitive.

Small Group, Large Market
The proposal may also allow more brokers to clear swaps for their customers instead of having to rely on other dealers for clearing services. JPMorgan, Bank of America Corp., Goldman Sachs, Morgan Stanley and Citigroup Inc. executed 95 percent of the $305 trillion in over-the-counter derivatives trades by the top 25 U.S. bank-holding companies as of Sept. 30, according to the Office of the Comptroller of the Currency. "It's the single biggest opportunity to come by the clearing broker marketplace for the better part of 10 to 15 years," Cawley said in an interview. "A lot of people are looking at this as a revenue opportunity."  Laurie Ferber, general counsel and executive vice president at MF Global, said in an interview that the company "would expect to be a member of every significant clearinghouse that is clearing interest rate or CDS swaps on a global basis." MF Global is already a clearing member of International Derivatives Clearing Group LLC, a clearinghouse majority-owned by Nasdaq OMX Group Inc.

Risk Increase

Wall Street's big banks say lowering the requirements for clearinghouses, which are capitalized by their members, may increase risk in the market. James Hill, managing director at Morgan Stanley and representative for the Securities Industry and Financial Markets Association, said clearing members must have "sufficient capital" and the ability "to trade very large amounts of very highly complex illiquid" over-the-counter derivatives. "And if they can't do that, by introducing them as a clearing member into the clearinghouse, you actually increase risk in the clearinghouse because at a time when a member is defaulting, the clearinghouse won't be able to absorb the losses," Hill said at an Aug. 20 CFTC hearing.

Fewer Restrictions
The CFTC proposal also would not allow clearinghouses to exclude members that are not swap dealers or restrict membership based on the size of a company's swaps portfolio. LCH.Clearnet requires that in addition to having $5 billion in capital, clearing members must have a notional interest rate swaps portfolio exceeding $1 trillion and be able to participate in a default management program. LCH.Clearnet Group Ltd. was "shocked" by the CFTC capital proposal, chief executive Roger Liddell said at a Jan. 25 Tabb Forum conference on derivatives in New York. "We don't yet know frankly whether we can live with a $50 million limit. That's not by any means certain," Liddell said. Gensler said clearinghouses could "scale" a member's participation depending on its amount of capital. Under the proposal, a clearinghouse could require each member to hold more capital in proportion to its level of risk. "The smaller capital you have the smaller the participation. The larger, the larger participation," Gensler said at Jan. 14 speech at George Washington University Law School. "You could scale folks but not exclude them necessarily if they weren't the 7-footers in the NBA."