Regulation: Dodd-Frank throws a long shadow on Wall Street

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By:
Hamish Risk
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Central clearing could erode market share; New exchanges set to take on banks

For the over-the-counter derivatives markets the signing into law of the Dodd-Frank Wall Street Reform and Consumer Protection Act last month was a watershed moment.

Although the ultimate intention of the new regulations is to make the financial markets sufficiently robust and secure to avoid the systemic failure of the biggest financial institutions, they might also ultimately lead to a break-up of an oligopoly that has been Wall Street’s most lucrative business line for the past 15 years.

In the first half of 2009 the top five banks made $35 billion from trading in derivatives, including interest rate and credit default swaps; and cash instruments such as treasuries and corporate bonds, according to reports compiled by the Federal Reserve. For JPMorgan, the biggest counterparty in the OTC derivatives market, half of its $31.2 billion of trading revenue between 2006 and 2008 came from derivatives.

At the core of the new regulation is the implementation of central counterparty clearing (CCP) for over-the-counter derivatives, increased minimum capital requirements for non-standardized derivatives that cannot be cleared, and the transfer of trade execution from the phone to swap execution facilities that provide advanced pre-trade and post-trade transparency, and regulated exchanges.

While Wall Street banks have spent the past two years lobbying their interests in Washington, the industry has broadly supported the regulations, particularly the move to CCP. At a securities conference in New York last month, Blyth Masters, who runs JPMorgan’s global commodities business – but was a pioneer of the bank’s derivatives business in the 1990s – told delegates that people shouldn’t lose sight of the fact that most of the best minds in the field had believed for years in the need for reform in the market.

Central clearing isn’t new for the banks, with interbank interest rate swaps having been cleared through LCH.Clearnet for the past decade, and credit default swaps for the past 12 months, but it is hard to see how they cannot avoid erosion of their market share.

Universal adoption of CCP effectively unlocks the hegemony of Wall Street’s largest firms, because historically, given the bilateral nature of the OTC derivatives market, those banks with higher credit ratings and larger balance sheets tended to be the preferred counterparties in derivatives transactions, primarily because they presented the least counterparty risk.

Under the new framework the clients’ counterparty exposure becomes the clearing house and thus the perceived strength of the counterparty is no longer important when they choose whom they do business with.

Already fault lines in the market are beginning to appear. Last month five Chicago-based trading firms formed a venture with the futures exchange CME Group to start a new exchange offering interest rate swaps. Called Eris Exchange, it is a venture between Getco, DRW Trading, Infinium Capital Management, Chicago Trading Company and Nico Trading.

The new contracts will be subject to the same rules as typical futures contracts, rather than the new rules stipulated in the legislation for OTC derivatives, but customers now have a choice: they can trade a swap pursuant to the new rules and regulations, or they can trade the economic equivalent.

The new contracts will be cleared through the CME and will be eligible for cross-margining with other futures products, something not yet available on OTC cleared contracts.

"If I’m JPMorgan in this new world, I’m less able to win market share based on my high rating and general perception as a strong counterparty"

Alex Yavorsky, Moody’s Investors Service

Alex Yarvosky, Moody’s Investors Service

 

"If I’m JPMorgan in this new world, I’m less able to win market share based on my high rating and general perception as a strong counterparty," says Alex Yavorsky, a senior analyst at Moody’s Investors Service in New York. "Not only has my competitive advantage become less relevant but I’m having to contend with these additional new entrants, such as electronic high-frequency trading firms, whose business model revolves around high volumes and tight bid-offer spreads on electronic trading. Clearly for the biggest incumbents, the neutralization of the credit and the influx of new entrants are threats."

Yavorsky says that volumes will naturally increase as more trading goes electronic and might mimic a similar trend that occurred in the equities markets in the 1970s, where the elimination of fixed commissions quickly led to price-based competition and a narrowing of bid-offer spreads. To maintain their competitive advantage, Wall Street banks will need to compete on the electronic trading front.

Yavorsky says banks that have existing equity trading platforms with a large market share of turnover, such as Goldman Sachs, with its RediPlus platform and Credit Suisse’s AES platform, have an advantage.

The use of electronic platforms, as Wall Street banks argue, will cut costs and increase profitability, either by cutting headcount or by redeploying resources to the more bespoke end of the derivatives market, where capital costs will be higher but margins are fatter.