Derivatives Regulation Could Be Bonanza for Clearing Houses
January 25, 2010
When the House passed The Wall Street Reform and Consumer Protection Act on December 11, Congress acted for the first time to regulate over-the-counter derivatives, a significant part of the financial markets that played an important role in the financial meltdown-and that still poses a potential risk to the broad economy.
Clearing houses could be big winners, as a result.
While the Senate is still in the initial stages of considering its own financial reform package, central clearing for standardized OTC derivatives, as mandated by the House bill, is likely to be written into law before long.
"The major issues will stay pretty close to what they are in the House," says Kevin McPartland, a senior analyst at New York-based research firm Tabb Group and author of "OTC Derivatives Regulatory Update," a report released January 11 on the outlook for derivatives regulation and its impact on the industry.
McPartland says clearing houses could be big winners, as they expand existing electronic systems to clear OTC derivatives contracts between member firms. In the case of standardized swaps contracts, the technology employed will streamline the post-trade process. This will remove considerable operational risk from the once-manual process of clearing OTC derivatives.
Mandatory clearing of OTC derivatives will be a significant step. In the past three decades, the OTC derivatives marketplace has ballooned to approximately $300 trillion in face value of contracts, according to the Commodity Futures and Trading Commission (CFTC). That is nearly 20 times the output of the U.S. economy.
Contracts have become more standardized. Rapid advances in technology facilitate more efficient trading-but setting down terms and finalizing those contracts is still largely a manual and spoken affair between two parties, often called a "bilateral process."
In this dealer-dominated market, "derivatives are intended to help transfer and lower risk in the economy, but the financial crisis demonstrated that they can also concentrate risk among a few big banks," CFTC Chairman Gary Gensler told the Atlantic Council, a public policy group, on January 12. To lower risk, standard OTC derivative transactions should be moved into well-regulated clearing houses, Gensler said, a move almost no one disputes.
Clearing houses should gain from any legislation with a clearing requirement. McPartland says that Morgan Stanley is estimating a profit potential of close to $1 billion by 2013 for the clearing houses, across all OTC product segments.
SYSTEM CHANGES
Along with the clearing requirement will come "big process changes," McPartland says, as the systems and processes now in place at the major dealers are modified from bilateral trades to trades that must be sent to a central clearing facility.
"Those trades need to be marked and formatted, subject to collateral and risk management [requirements]-There will be a number of changes in moving a vanilla CDS from a bilateral process to a centrally cleared one," he said in an interview. "The entire process flow will have to change, including trade confirmations, trade capture, format, the way trades are recorded for risk management purposes, and the way collateral is calculated."
McPartland expects considerable re-working of dealer systems to accommodate new trade flows that include central clearing as well as existing non-cleared ones. Besides the clearing firms, he says that derivatives-focused technology firms such as Calypso Technology and SunGard Data Systems are positioned to benefit from changes in the process and the increased need for automation.
