Dodd bill may give trading edge to CME

Senate legislation to regulate the $605 trillion private derivatives market may cut into Wall Street profits more than a House bill passed in December by moving most trades to exchanges or similar systems.

At stake is trading revenue in unregulated markets that last year generated an estimated $28 billion for five U.S. dealers including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley, according to company reports collected by the Federal Reserve and people familiar with banks' income sources. Forcing privately negotiated swaps to trade on exchanges would reduce bank profit because dealers would no longer control the prices offered on the contracts.

"The Dodd bill is the most exchange-model friendly," said Andrew Lowenthal, president of Washington-based lobbying firm Porterfield, Lowenthal & Fettig LLC and a former chief of staff to the Commodity Futures Trading Commission, which regulates futures exchanges. "The idea really is to try to facilitate the development of these markets."

The Senate bill, introduced by Banking Committee Chairman Christopher Dodd, would require the most-active swaps to be traded on systems that show prices beforehand and can sell or transfer open positions if a party to the transaction defaults. That would create de facto exchange trading for standardized swaps, said Kevin McPartland, a senior analyst with Tabb Group.

JPMorgan alone could lose up to $3 billion a year in revenue if it doesn't combat the move to exchange trading, Morgan Stanley analysts said in a March 15 report. The bill by Dodd, Democrat of Connecticut, passed the Senate Banking Committee last month and could be taken up by the full Senate later this month.

The move to exchanges or electronic systems would be a big change from how brokers now put trades together over the phone, the way most of the over-the-counter derivatives market has operated for its 30-year history. Dodd said the increased transparency provided by exchange trading is needed to address the systemic risk posed by swaps markets.

The debate is intensifying as Congress seeks to complete legislation on financial regulation that it's been crafting for a year, after bets made with credit-default swaps pushed American International Group Inc. to the brink of failure and Lehman Brothers Holdings Inc., one of the biggest swaps dealers, filed for bankruptcy.

Exchanges such as CME Group Inc., the world's largest futures market, and Intercontinental Exchange Inc., owner of the world's largest credit-default swap clearinghouse, could benefit from the legislation. Exchanges, which charge a fee for executing trades, would add to the $1 billion in annual revenue Morgan Stanley estimates they will earn worldwide by 2013 from processing over-the-counter swaps with their clearinghouses.

Companies, hedge funds and other money managers that use bilaterally negotiated swaps need to be able to execute trades off exchanges, often on customized terms, in order to effectively hedge against potential losses on everything from rising interest rates to dropping commodity prices, according to Christopher Giancarlo, chairman of the Wholesale Markets Brokers' Association Americas.

The bill "jeopardizes the ability for these robust markets to remain a source of liquidity for American businesses by imposing a monopolistic market structure on the trade execution of cleared transactions," Giancarlo, executive vice president at inter-dealer derivatives broker GFI Group Inc., wrote in a March 30 letter to members of the Senate Banking Committee.

The association's members include inter-dealer brokers ICAP Plc, GFI, BGC Partners Inc. and Tullett Prebon Plc. Inter-dealer brokers put together trades between banks.

"We need the glaring light of sunshine so that the American people can know what risks are out there," Dodd said in an e-mailed statement. "Derivatives traders are only fighting it because if their customers have access to more information they will be able to shop around for better deals."

U.S. Deputy Treasury Secretary Neal Wolin said the Obama administration will "fight hard against any efforts to weaken" the Senate's bill overhauling financial regulation, which he called "comprehensive and strong" at a Council of Institutional Investors conference in Washington today.

Justin Perras, a spokesman for JPMorgan, Michael DuVally, a Goldman Sachs spokesman, and Jennifer Sala, a spokeswoman for Morgan Stanley, declined to comment.

Lawmakers have focused on requiring that most swaps trades move through clearinghouses to improve the OTC derivatives market structure to allow regulators to monitor positions and prices. Trades that aren't sent to clearinghouses would face higher capital charges and be required to be reported to trade repositories. Clearinghouses, which are capitalized by their members, are designed to absorb the failure of a major dealer or investor.

Dodd's wife, Jackie Clegg, is a CME Group board member and shareholder, with stock valued at $235,000, according to Bloomberg data.

"We don't believe there is a conflict of interest," said CME Group spokesman Michael Shore. Clegg couldn't be reached for comment.

Both the House and Senate bills stipulate how contracts that are to be cleared must trade, though Dodd's bill would bring tougher restrictions on execution and, unlike the House version passed in December, would bar cleared swaps from being traded by telephone.

Dodd's bill lays out two potential venues to trade interest-rate, credit-default or other kinds of swaps that will be cleared. Parties could use exchanges or regulated "alternative swap execution facilities," which the legislation defines as an electronic platform offering "pre-trade price transparency" that would have the capability to "liquidate or transfer open positions in any swap."

Tabb Group's McPartland said that language was tantamount to an ASEF being defined as an exchange. "It's completely a clearing function," he said. "It doesn't fit within the definition of an execution facility."

Neither Chicago-based CME Group nor Atlanta-based Intercontinental currently plans to execute swap trades on their exchanges. CME Group did include execution in its original credit-default swap initiative, a partnership with hedge fund Citadel Investment Group LLC, before dropping the idea amid opposition from banks that deal in the products.

The WMBA's Giancarlo agreed that Dodd's bill sets up the equivalent of exchange trading for swaps.

"When taken together with the draft's definition of an ASEF, the only conclusion that one can come to is that the current bill designs an ASEF to effectively function as a monopolistic futures exchange," he wrote in the March 30 letter.