How Dealer Profitability Will Improve, Not Shrink, Under New Derivatives Regulation

The key element of derivative market reform is a central clearinghouse, the central counter party ("CCP"). Standardized derivative transactions must be cleared through the CCP that guarantees performance, reducing the risk of market participants defaulting on obligations. The CCP and its attendant structural paraphernalia is designed to bring transparency to mysterious instruments and prices, shedding light on the magic! Contrary to the popular narrative, current proposals will not impact significantly on dealer earnings. Derivative dealers have resisted clearing, primarily because of the effect of greater transparency on profit margins. The five largest U.S. derivative dealers alone generate annual revenues of at least $60-70 billion from trading derivatives and cash securities. Global revenues are probably two to three times that number. Only standardized derivative transactions are likely to requiring mandatory clearing. Lucrative non-standardized derivatives will continue to be traded in the opaque over-the-counter ("OTC") markets, preserving dealer profits. The CCP also creates profitable new opportunities for dealers. Derivatives eligible for clearing must be traded via a regulated exchange or through an alternative swap execution facility ("SEF"), that is open to multiple participants. In the oligopolistic world of OTC derivative trading, fewer than 10 dealers (nicknamed "The Derivative Dealers Club" by Robert Littan of the Brookings Institute) control the vast majority of trading activity. These dealers provide the bulk of trading volume, which will dictate the success or failure of individual SEFs. Dealers will parlay their control of volumes into control of trading, through de facto ownership or influence over the dominant platforms. Dealers will play a crucial role in clearing on behalf of client and non-dealer financial institutions. The clearing model is unlikely to require all participants to deal with the CCP directly. Instead, non-clearing participants will deal through a CCP clearing member (known as a clearing broker or in the US a futures clearing merchant). Non-clearing members will have no direct relationship with the CCP, lodging margins with the clearing member who deals with and is accountable to the CCP for payments and contract performance (a system known as "net clearing"). Under this arrangement, the clearing dealer will negotiate arrangements with clients, including the level of margins, the form of collateral permitted, netting of positions, the timing for meeting margin calls and the clearing fees. Clearing dealers may also provide credit facilities, funding margin calls on behalf of clients, enabling trading without credit enhancement. Under the CCP, dealers will gain a profitable business clearing non-member trades. In existing exchange traded markets, most of the profits from futures broking comes from not from execution but clearing, including crucial access to client funds that can be reinvested at a profit. Only a few large derivative dealers have the capita resources to finance the large capital investment required to support the systems and infrastructure for trading platforms and clearing through the CCP. Other dealers will inevitably be forced to trade, clear and settle trades through these dealers. This will perversely create credit risk as well increasing systemic risk and problems of concentration. The CCP system has competing objectives, which may prove irreconcilable in practice. Regulators want to encourage competition, broadening the range of SEFs and clearing houses by lowering eligibility thresholds. However, inadequately capitalized smaller members would increase risk for other members and the CCP, in the event of a collapse of a member. Large highly capitalized banks argue that risk management considerations favor higher capital requirements, which would help ensure their dominant position. Proposed ownership restrictions of SEFs and clearing houses may not be effective. Dealers have historically been adroit at using the hunger of market infrastructure providers for volume to enhance revenues from commercial arrangements other than direct ownership, such as revenue sharing, volume rebates and other incentives. Regulators have generally tolerated concentrated ownership and oligopolies in market infrastructure, such as SEFs and clearing houses, citing economies of scale and scope as well as limited anti-competitive effects. While true in standard, simple debt and equity securities, it is not clear that this is the case with OTC derivatives. OTC derivative markets already exhibit high concentration, more complex instruments (frequently with non-transparent values), and greater information disparities between participants. The position of major dealers is likely to be strengthened, rather than weakened. Lower profit margins from any increased transparency and liquidity will be offset by new revenue flows from investments in SEFs and CCP, earnings from clearing on behalf of clients and efficient cash arbitrage of client margins and collateral. This is at odds with the dire predictions emanating from leading banks, arguing that the CCP and other regulations will cripple trading and decimate profitability. A framework for clearing OTC derivative will emerge, if only because finance ministers, central bankers and regulators have invested too much political capital in the proposals. Whatever is implemented will be reminiscent of French philosopher Jean Paul Sartre's words: "Once you hear the details of victory, it is hard to distinguish it from a defeat." Earlier versions of this piece have been published as "Tranquilizer Solutions Part I: A CCP Idea" and "Tranquilizer Solutions: Part 2 – CCP Risk Taming" in Wilmott Magazine (May and July 2100)