Banks Square Off on Derivatives

Big derivatives dealers and mid-sized ones sparred over rulemaking Friday.
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NEW YORK (

TheStreet

) -- Derivatives markets participants met in Washington D.C. Friday to begin hammering out the implementation of new laws governing the market for over the counter (OTC) derivatives, estimated at $631 trillion globally.

The major change is that many OTC derivatives, which used to trade bilaterally, will have to be cleared through a central clearing facility. The idea is to allow risk to be distributed among several firms, rather than just the two that enter into the trade. Regulators hope central clearing of OTC derivatives will prevent a repeat of the type of chaos that ensued following the collapse of

Lehman Brothers

in Sept. 2008.

The main argument during the first hour of a three hour roundtable was between a representative of small and mid-sized firms, who argued they are in danger of being shut out of the market, and a

Morgan Stanley

(MS) - Get Report

executive, speaking on behalf of Wall Street's major trade group, who said the goal of open access had to be balanced against concerns over the soundness of the central clearing facilities.

Jason Kastner, vice chairman of the Swaps and Derivatives Markets Association, which represents small and mid-sized dealers including

Jefferies Group

(JEF) - Get Report

, says the system is rigged by the big firms to keep small and mid-sized players out.

Kastner says one of his members, "a very large clearing bank that clears $21 trillion of Treasuries," was not allowed to become a clearing member of

LCH. Clearnet

a leading clearinghouse for interest rate swaps and other products whose board includes executives from

JPMorgan Chase

(JPM) - Get Report

,

Goldman Sachs

(GS) - Get Report

, Morgan Stanley,

Barclays PLC

(BCS) - Get Report

and

Citigroup

(C) - Get Report

and other large multinational banks.

A London-based spokeswoman for LCH. Clearnet declined to comment.

Jim Hill, the Morgan Stanley executive, said clearing members must be able to absorb positions if another member defaults.

"They have to be able to trade very large amount of highly complex illiquid OTC derivatives, and if they can't do that, by introducing them as a member into the clearinghouse you actually increase risk in the clearinghouse," Hill said.

Another issue that came up at the roundtable was which products should be cleared. Darrell Duffie, a Stanford University professor, argued regulators should not mandate that specific products be cleared, as he says is being proposed in Europe.

Duffie fears regulators "in their best efforts" might mandate the clearing of products that are not appropriate, leading to less clearing in general and "spurious customization of products designed to avoid clearing of products that are not economical." Instead, he advocates the use of capital and collateral requirements as incentives to encourage more clearing.

--

Written by Dan Freed in New York

.

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