By Matthew Leising
May 14 (Bloomberg) --
U.S. regulators may impose the same price reporting and transparency requirements on over-the-counter derivatives that reduced bank profits by almost half in the corporate bond market when the Trace system was adopted seven years ago.
“I think it’s something we’ll look at very closely as a
potential model,” Securities and Exchange Chairwoman Mary
Schapiro said yesterday at a news conference in Washington, in
which regulators laid out potential structural changes to
improve policing of the $684 trillion OTC derivatives market.
Trace, the bond-price reporting system of the Financial
Industry Regulatory Authority, gives anyone with an Internet
connection access to trading data for corporate bonds. The
system, in full operation since February 2005, reduced the
difference in prices that banks charge to buy and sell bonds by
almost half.
Treasury Secretary Timothy Geithner, Schapiro and Michael
Dunn, the acting chairman of the Commodity Futures Trading
Commission, called for increased oversight of over-the-counter
derivatives to reduce risk to the financial system. Lax
regulation contributed to the failures last year of Lehman
Brothers Holdings Inc. and American International Group Inc.,
leading to the seizure of credit markets and causing more than
$1.4 trillion in writedowns amid the worst financial crisis
since the Great Depression.
‘Accept the Reality’
“Dealers have to accept the reality that this business --
where margins were compressing already -- is getting less
profitable,” said Stephen Bruel, research director for
securities and capital markets for Tower Group, a research and
advisory firm in Needham, Massachusetts. “A lot of the action
you’ll see is to contain the size and scope and profitability of
this market.”
The bid-ask spread on investment-grade corporate bonds was
about seven basis points before Trace was implemented and about
four basis points immediately after, according to a study by
Kumar Venkataraman, an associate finance professor at Southern
Methodist University’s Cox School of Business in Dallas,
published in the Journal of Financial Economics. A basis point
is 0.01 percentage point.
Schapiro helped developed the Trace system in 2002 when she
was president of the NASD, which was consolidated into Finra.
Schapiro, Geithner and Dunn pledged at the news conference to
work together on changes in the market.
‘Significant Gaps’
“Significant gaps in the basic framework of oversight over
critical institutions” helped cause the financial crisis,
Geithner told reporters. “A series of comprehensive reforms to
create a stronger system, less vulnerable to crisis, with
stronger protections for consumers and investors” will be
hashed out with Congress, he said.
Part of his plan is to push banks to increase price
transparency by adopting electronic trading systems for over-
the-counter derivatives. Over-the-counter derivatives
transactions are now typically conducted over the phone between
banks and customers.
Geithner sent a proposal to Congressional leaders listing
four main objectives: to protect against systemic risk by
creating a more resilient market, improve efficiency and
transparency, prevent manipulation and fraud and reduce risks to
less-sophisticated investors, Geithner said.
“Some of the U.S. authorities have said we were pretty
close to a meltdown and I actually think listed marketplaces
with multilateral clearing are part of the answer to that
question,” said Thomas Kloet, chief executive officer of TMX
Group Inc., owner of Canada’s main equities and derivatives
market. “I hope authorities don’t let go of that. I think they
have to address that.”
Shares Rise
Shares of CME Group Inc. and Intercontinental Exchange Inc.
rose yesterday after Bloomberg News reported Geithner’s plan.
Chicago-based CME Group, the world’s largest futures exchange,
soared $15.62, or 6 percent, to $274.10 as of 4 p.m. in Nasdaq
Stock Market trading. Intercontinental of Atlanta, the second-
largest U.S. futures market, rose as much as 5.2 percent, before
closing up 9 cents to $96.59 on the New York Stock Exchange.
“This is the best Wall Street can hope for,” said James
Cox, a securities law professor at Duke University in Durham,
North Carolina. “This will allow them to stay in business and
still make money. It also cuts off what potentially would have
been more regulation.”
Once a Day
Only about 10 percent of bank customers use electronic
systems to trade over-the-counter derivatives, according to Paul
Zubulake, a senior analyst with Boston-based Aite Group. That
compares with about 90 percent of inter-bank trades that are
done electronically through inter-dealer brokers such as London-
based ICAP Plc or Dealerweb, according to Zubulake.
Prices for indexes of credit-default swaps, contracts used
to hedge against or speculate on corporate debt, have been made
public once a day since March by Markit Group Ltd. and
Intercontinental Exchange, the first company to guarantee the
contracts with a clearinghouse. Prices for other over-the-
counter contracts, such as interest-rate swaps, are not widely
available.
The need for transparency in the over-the-counter
derivatives market was stressed by Theo Lubke, a senior vice
president at the Federal Reserve Bank of New York, last month at
a derivatives industry conference in Beijing.
More Information
Lubke, who was appointed in 2007 to oversee OTC derivatives
by Geithner when he was president of the New York Fed, said the
credit swap prices now available are not sufficient, according
to a transcript of his comments.
Because investors don’t know when trades took place or how
many occurred, more information is needed, he said April 23 at
the International Swaps and Derivatives Association general
meeting in Beijing.
“That window of opportunity to make changes as opposed to
having those changes brought to the market by external forces is
narrowing,” he said. “It is in market participants’ interest
as well as the interest of regulators to see continued rapid
movement.”
Derivatives are contracts whose values are tied to assets
including stocks, bonds, commodities and currencies, or events
such as changes in interest rates or the weather.
“ISDA welcomes the recognition of industry measures to
safeguard smooth functioning of privately negotiated
derivatives,” Robert Pickel, chief executive officer of ISDA,
said in an e-mailed statement.
Lubke said at the ISDA conference that the major banks’
control of the over-the-counter derivatives market must end by
allowing hedge funds and other investors more input into how
market decisions are made.
“It is simply unacceptable in today’s environment that the
design and structure of the OTC derivatives market can be
controlled by a handful of large dealers,” Lubke said. “There
is opacity in the OTC market that doesn’t have commensurate
public policy benefits,” he said. “This is not something that
can continue.”
Matthew Leising in New York at
mleising@bloomberg.net
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