From the July 01, 2011 issue of Futures Magazine • Subscribe!

Dodd-Frank: Why the holdup?

Stop the world!

Major banks that control the bulk of the $600 trillion OTC derivatives market and its shadow banking system have long opposed the reforms. They’ve also taken much of the heat for slowing down the pace of implementation — generally because they argue that most of the products trading OTC don’t lend themselves to exchange trading.

"They’ve been saying this for years, and lawmakers generally listen because it’s not their area of expertise," says Christian Baum, a London-based derivatives consultant and former Eurex product developer. "The fact is that 90% of these allegedly complex swaps are fairly commoditized at their core and easily can be moved on-exchange — or at least cleared."

That contention may be open to debate, but there’s no denying the value to major investment banks of keeping these products in the shadow economy. JP Morgan CEO Jamie Dimon, for example, has told shareholders that the new rules could cost his bank $2 billion per year.

The big banks, however, are far from alone in holding up the implementation of Dodd-Frank. Even exchanges and clearinghouses — which stand to win big as business migrates to their platforms — fear a shift from principles-based regulation to rules-based regulation at the CFTC. Others warn that we risk running out of synch with the European Union, which is at least a year behind the U.S. regulation (see ""). Asian regulators — most notably in Hong Kong and Singapore — have talked of creating friendlier regulatory environments, prompting House Financial Services Committee Chairman Spencer Bachus to warn that we’d only be sending business overseas by implementing a strong regulatory regime.

Finally — and shockingly — a new report called "Interest Rate Derivatives 2011: Collateral Damage in the Duration Market," published by the TABB Group, shows that participants just have begun to realize the impact that new capital requirements will have on their bottom line as Dodd-Frank, Basel III and European regulations kick in.

"Nearly 50% of [interest] rate traders believe that financial regulatory reform will be the leading force of change in their markets over the next year," the report says. "If implemented in its current form, and mimicked by similar efforts in Europe, UK and other major currency centers, (Dodd-Frank) could have impacts far beyond the hedging of interest rate risks."

Another report, "Expansion of Central Clearing," published by the Bank for International Settlements (BIS), concluded that the world’s 14 largest derivatives dealers (G14) had more than enough money to meet initial margin requirements, but they might need to free up billions within a day if volatility spikes.

"These margin calls could represent as much as 13% of a G14 dealer’s current holdings of cash and cash equivalents in the case of interest rate swaps," they wrote — a fact that underlines the importance of a robust clearing system.

Clearing conundrum

For as long as there have been OTC derivatives, there have been exchange executives calling for their regulation. Dodd-Frank answered that call, but it’s not the answer many initially believed it to be.

First, Dodd-Frank left the default treatment of OTC derivatives uncleared, but imposed massive capital requirements on any practitioners who weren’t using a clearing facility. Then, it called for the "Commission" (the SEC and CFTC) to review periodically the types of derivatives that are required to be cleared centrally.

It also created something called a Swap Data Repository (SDR), which is to keep track of all swaps.

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