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A Replacement for Goldman Prop Trading?

Goldman will have plenty of competition in its new derivatives clearing business.
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Goldman Sachs

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appears to believe a new derivatives clearing business will help it shrug off the impact of regulatory changes and the loss of proprietary trading revenues, but many are skeptical.

Goldman's announcement of a new clearing business last month coincided with widespread reports about the likely fate of Goldman's proprietary trading businesses. Proprietary trading has been a big source of profits for Goldman, and new laws are aimed at curbing much of that activity. Many are wondering how Goldman will make money in the new environment, and some see derivatives clearing as part of the equation.

Goldman has long supported central clearing in the $615 trillion over the counter derivatives (OTC) market. Currently, OTC derivatives settle "bilaterally" by having each side of a trade follow the terms of the original contract. But this has caused confusion, as exemplified by the collapse of

Lehman Brothers

when the derivatives market seized over the sheer volume contracts that needed to be settled.

Now that central clearing is being mandated by regulators, Goldman management sees it as a "net positive," and one of three "key opportunities", along with asset management and emerging markets, according to a report by Bank of America analyst Guy Moszkowski.

The thinking of Goldman management, according to Moszkowski's report, is that "thinner spreads resulting from clearing and exchange trading will be offset by a surge in volumes, as has historically been the case for all markets where trading costs have declined sharply because of 'digitization' or other changes."

But Goldman faces many doubters. "I think it's more of a regulatory reaction rather than a new opportunity that's going to produce abnormal profits going ahead for Goldman," says Ed Grebeck, CEO of Tempus Advisors and a New York University professor.

Certainly Goldman will face lots of competition, both from other large banks and from derivatives brokers like

MF Global


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, which appears to have a new life under former Goldman boss and New Jersey governor Jon Corzine.

Goldman spokesman Ed Canaday declined to comment on how Goldman's clearing business will respond to competitive threats, though he made clear via e-mail that Goldman does not operate under the illusion it is alone in the space.

"I'm not familiar with the services provided by other dealers, but I imagine there are others who offer similar services or are looking to do so in the future," he wrote.

Banks that say they are offering derivatives clearing services include

JPMorgan Chase

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Bank of America

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Deutsche Bank

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Credit Suisse

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Morgan Stanley

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did not respond to questions.

"Every dealer that is a major swap participant or major swap counterparty is going to want to offer clearing services," says Bob Burke, head of over the counter derivatives clearing at Bank of America.

But a critical advantage currently enjoyed by many large banks including Goldman will go away once derivatives are centrally cleared, says Chris Concannon, senior partner at market maker Virtu Financial and former head of trading at Nasdaq.

"JPMorgan arguably has one of the best balance sheets in the globe. They win business today because of their balance sheet. Who would you want to face off on a 10-year interest rate swap? You ask yourself who you think will be around for 10 years on that interest rate swap and you select JPMorgan. When this goes centrally cleared, your 10-year interest rate swap is now cleared by this well-funded, highly- regulated clearing house. You'll go through any party because you end up at the same place: a cleared instrument. That environment creates competitive pricing," Concannon says.

A JPMorgan spokesman declined to respond to Concannon's comments.

What Goldman and the other banks will do is allow customers to access clearing facilities such as

ICE Trust


CME Group

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, for credit default swaps, or

LCH. Clearnet


International Derivatives Clearing Group

, which are leaders in interest rate swaps. Because many of their customers will not want to go through the expense of becoming clearing members themselves, the banks will act as gatekeepers to those facilities.

Banks will collect margin payments from clients to back their trades, and the banks will help them "net out" different exposures so that, if they have separate trades that offset one another, they may not need to post as much collateral. Clients will also benefit from something called "portability," meaning if they don't like the clearing member they are using, or if that institution defaults, the client can transfer its position to another clearing member.

Some banks, of course, will prove far better at providing these services than others, though it seems a safe bet that those that dominated the derivatives business when it operated in the shadows will invest heavily as Goldman is doing to maintain their market share in the new environment.

In the meantime, expect regulators to take a long time to sort out what must be cleared. The early indication from regulators is that products much be "liquid"--i.e. trade regularly--and that they must have an underlying price. Estimates vary widely on how much of the $615 trillion over the counter derivatives market has those characteristics.


Written by Dan Freed in New York


Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.