As Congress irons out OTC derivatives reform, buy-siders push for transparency, including central clearing and trading on exchanges.

After tinkering with the details of OTC derivatives reform. the House of Representatives passed a broad set of measures to overhaul Wall Street today. The financial reforms passed with a vote of 223 to 202, without a single Republican vote. Even so, the legislative process is expected to drag into 2010, because the Senate, which is not as far along as the House, is not expected to take up a similar proposal until early next year. While no one is quite sure how the final legislation will turn out, industry analysts and market participants expect a major overhaul of the $600 trillion opaque marketplace, which has eluded regulation till now.

While the House Financial Services Committee and the House Agricultural Committee have passed two different bills. the full House of Representatives came together to vote on a single bill on Dec. 11th. That compromise bill will go to the Senate, where the Banking Committee, led by Sen. Christopher Dodd (D-Conn.), will negotiate with the Senate Agriculture Committee on their respective financial reform plans.

Ultimately both houses of Congress must work together to create a single bill before it reaches the president to sign into law, notes Kevin McPartland, senior analyst at TABB Group. But McPartland doesn’t expect a final bill to land on the president’s desk until the spring or even until the August 2010 recess.

Though the details of the various bills are still being ironed out, most industry sources predict that Congress will insist upon mandatory central clearing for all standardized derivatives contracts and force trading onto exchanges or regulated electronic platforms. I’m very confident that the final bill that gets to the president’s desk will include [those stipulations], says Paul Zubulake. senior analyst at Aite Group.

Buy-side supporters of the regulatory proposals argue that transparency will level the playing field for asset managers and proprietary-trading firms that use the custom contracts to hedge their exposures or speculate on the movement of oil prices, interest rates or currencies. Any time you can standardize contracts and have them go to a clearing house where you remove counterparty exposure and you’re able to collect more information for the marketplace about how they work, that is a better alternative for investors, comments Basil Williams. CEO of Concordia Advisors, an international multistrategy hedge fund in New York.

Buy-side portfolio managers insist they would benefit from listing OTC derivatives on exchanges. If they go to an exchange, I would see more trading volume and more market participants, explains Williams, whose firm is active in both credit default swaps and interest rate swaps.

According to Williams, central clearing will ensure smoother operational processes and reduce counterparty risk concerns. Even if an institution has four dealers as counterparties, it will have a single collateral posting, he notes. All that will be netted, says Williams, who adds that outstanding contracts will be offset and risk will be taken out of the global financial system.

The big winners are likely to be consumers of derivatives that previously were at an information disadvantage and exchanges that will be able to list and clear these contracts and develop new sources of revenues, according to Niels Nygaard, director of the financial mathematics program at the University of Chicago. Consumers of derivatives up to now have been forced to go to the banks and call around and see where they can get the best price, he explains. But if the contracts are listed on an exchange, they can get the total market price — a bid and an ask — from the market, which is far superior to what they do now.

Nygaard points out that proprietary trading firms are excited about the opportunity to trade OTC derivatives. Once the clearing and counterparty risk is out of the picture, then it will make the market more efficient and flexible, he asserts. Noting that pricing currently depends on the customer’s relationships with the dealers, Nygaard adds, The counterparty risk is going to be factored into prices sometimes, and that’s very hard to quantify.

Shedding Light on Pricing

Most asset managers agree that there is a lack of price transparency in the OTC equity derivatives. I’d like more information on the volatility that’s traded in the particular options on a name,says Stephen Davenport, VP and head of equity risk management for Wilmington Trust in Atlanta. If OTC option trading in Microsoft were 50 times what it is in the listed market, and that moves over [to an exchange], the volatility those [instruments] trade at is going to reprice or influence the pricing of the listed market. Right now this is going on in the backroom — everything is between the two parties, the dealers and the customer. Nobody knows how big the volume is in OTC equity options.

Current rules favor the top dealers in OTC derivatives, industry sources contend. According to published reports, the OTC derivative market is heavily dominated by a few financial firms: JPMorgan Chase, Goldman Sachs, Bank of America, Citi and HSBC account for 97 percent of the notional amount of all derivative contracts.

The dealers have been making abnormal profits, says Davenport. If we put everything out into the light and those profits can be maintained, then they’re justified. But if we put them out [and find] that other people are offering terms and conditions that are better, then people will gravitate to who’s giving better pricing, and then the margins will contract.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad. View Full Bio