Markets

Why It's Crazy to Let Wall Street Control Derivative Exchanges

By Alain Sherter

Updated on: June 28, 2010 / 5:32 PM EDT / MoneyWatch

The financial reform bill seeks to curb Wall Street's taste for derivatives by moving most swap trading to regulated clearinghouses. Yet a provision quietly dropped from the legislation last week could cement big banks' control over the very exchanges that are intended to make the capital markets safer.

Under pressure from the financial industry, lawmakers cut an amendment that would have limited banks' ownership in the clearinghouses to 20 percent. Instead, regulators can set the threshold -- or not (a real possibility, given federal watchdogs' deference to Big Finance in recent years).

This isn't a mere technical detail. The arrangement would leave the five "broker-dealers" that dominate the derivatives market -- Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), JPMorgan Chase (JPM) and Morgan Stanley (MS) -- with enormous influence over how quickly swap clearinghouses take shape, their operating rules and their efficacy.

The foxes wouldn't be guarding the henhouse so much as renting it out. As bank analyst Chris Whalen, managing director of investor advisory firm Institutional Risk Analytics, recently told CNBC:

The OTC market -- the monopoly -- is increased by this legislation. [Sen. Chris] Dodd and [Rep. Barney] Frank are handing JPMorgan and the other big guys who can interface in a clearing environment the keys to the kingdom.

Why should we worry if Wall Street controls clearinghouses? For one, they have a financial interest in seeing them fail, since flourishing exchanges would push banks to the sideline in the enormously lucrative swaps business. Second, banks could be tempted to lower the standards for using the exchanges, such as margin requirements, to deter derivative buyers from using competing clearinghouses.

Wallace Turbeville, a former Goldman VP who now blogs for a centrist think-tank, notes that banks historically have sought to control the underlying structures where trading occurs. And he warns against allowing Wall Street to extend that dominance to clearinghouses:

It has never been more important to secure the independence of market infrastructure from the banks. With regulatory reform in place, the ability to avoid its intended purpose by influencing the mechanisms of the market to enlarge gaps in regulation will be a central goal of the financial institutions. They must be told that the infrastructure is not theirs to use to avoid regulatory control.

Third, and perhaps most troubling, allowing banks to control clearinghouses undermines their basic premise -- reducing the chances of an AIG-like systemic collapse if a big derivatives user blows up. Along with excessive leverage, a major reason financial markets seized up in 2007 was the degree to which "too big to fail" firms were interconnected. Linking a handful of big banks through common ownership of a swaps clearinghouse increases, not reduces, those connections, which in turn concentrates risk.

As the reform bill moves ahead, one thing to look at is whether regulators ultimately force banks to open up existing clearinghouses. Wall Street firms last year joined with IntercontinentalExchange (ICE) to launch a clearinghouse for OTC derivatives. The banks effectively bar smaller broker-dealers from joining the clearinghouse by requiring them to have a swaps desk or have a net tangible worth of least $5 billion.

ICE Trust, as the clearinghouse is called, is effectively an oligopoly. The company's owners -- Wall Street -- can use that market power to slow down the transition to central clearing. As Robert Litan, a fellow at The Brookings Institution, put it in an April report:

[A]s long as ICE Trust has a monopoly in clearing, watch for the dealers to limit the expansion of the products that are centrally cleared, and to create barriers to electronic trading and smaller dealers making competitive markets in cleared products.

Other key market players involved in derivatives trading also are largely controlled by big banks. The Depository Trust Clearing Corp., the main source of credit default swap data, serves at the pleasure of its bank customers. And Markit, the chief provider of pricing info for derivatives, is owned by a several Wall Street banks, including JPMorgan Chase and B of A. Says Litan:

Pricing data is the "oxygen" that enables financial markets to thrive. As long as these data are controlled by the entities whose economic interest is to slow constructive reform, then users of derivatives will continue to trade with less information than is now routinely available to participants in markets for stocks and futures, especially as long as many derivatives can be kept off exchanges.

The financial reform bill was deeply flawed. But one thing it got right was ordering the use of swaps clearinghouses, a crucial step in lighting up the "shadow banking system." It would be boneheaded -- and dangerous to the financial system -- to entrust the future of those exchanges to firms with an interest in exploiting them for their own ends.

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