Who Profits From Derivatives Changes?

It looks like the CME and ICE will eventually cash in as Washington aims to move derivatives to a more transparent trading environment.
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Regulation of all of those nasty derivatives that helped caused the fall of Lehman Brothers and hastened the economic decline last year has definitely been on the minds of the Obama administration and Treasury Secretary Tim Geithner.

For months, the administration has been gathering ideas and proposals on how to get control of an almost $600 trillion market traded over the counter, outside of the regulated and monitored exchanges and with very little oversight.

From all indications, Geithner's plans will not be quite as forgiving and "hands off" as his predecessor Hank Paulson's, and the banks seem to be aware of this.

In February, a combined proposal letter from

Goldman Sachs

(GS) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

and

Barclays

(BCS) - Get Report

went to Treasury with suggestions about how to shape the forthcoming regulation. That letter surfaced only recently, and the indications are that it was received positively by the Treasury Department. Much of what was in that proposal will be adopted by Treasury.

Buy ICE and CME

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In that letter, the banks suggested equal capital requirements for other participants in the derivative markets similar to whatever will be demanded of the banks themselves -- admitting that the "margining" of these instruments have been insufficient in the past.

But this increased burden of capital also brings a benefit to the investment banking community: in essence increasing the barriers of entry to the lucrative OTC markets from outside hedge funds and insurance companies.

And while supporting increased "transparency" of the derivatives markets, the proposal didn't go so far as to suggest that all over-the-counter trading needed counterparty clearing through a regulated exchange like the

Chicago Mercantile Exchange

(CME) - Get Report

or the

Intercontinental Exchange

(ICE) - Get Report

.

For the $29 trillion dollar credit default swaps market, which was specifically blamed for the Lehman and

AIG

(AIG) - Get Report

disasters, Treasury has indicated that these instruments will have to be migrated to one of the domestic exchanges and be subject to the rigorous capital, margin and reporting requirements of other publicly traded commodities like gold and oil.

So what will all this mean to the bottom line for these companies?

For the banks, there is sure to be less of a profit to be made from the gargantuan derivatives market than in the past. The more that derivative trades of all types are forced into the open by exchange clearing and stricter capital requirements, the less possible it becomes to create customized, complex and expensive products for clients.

Derivative sales and trading have been a huge portion of profits for the investment banks in recent years, by some estimates amounting to up to 40% of profits for Goldman Sachs and Morgan Stanley, according to fixed-income research firm CreditSights Inc.

The big winners will certainly be the regulated exchanges, called upon more and more to be the locus for the trading and the clearing of these markets. The first market to migrate to the exchanges will be credit default swaps, which are the initial focus of Treasury's regulatory hammer.

While both the Intercontinental Exchange and the CME have been competing for the business of trading and clearing this market, it now seems clear that the ICE will win the enormous majority of this business. While full migration of this market will take years, it will be an enormous profit boost for the Atlanta exchange and it continues to make ICE stock attractive as a longer-term investment.

For the rest of the humongous derivative markets, it is looking more and more that Treasury would like to apply the same types of regulations as it is moving toward with credit default swaps. Enormous and untouched OTC markets in oil, interest rates and other commodities amount to a notional value almost 20 times that of the CDS market. With that kind of new trading and clearing business perhaps now up for grabs, the CME clearly leads the pack in its proven ability to oversee and operate transparent derivative commodities and will be the biggest beneficiary of oncoming regulation.

On the backs of continued talk of regulation and the continued push to migrate OTC markets from the offices to the "screens" of the CME, the stock has pushed aggressively higher, moving from a low of around $150 a share to trade today at roughly twice that.

Even with this big up move, the CME has been a mercilessly beaten-up stock through the crash of '08, coming from a high point of over $700 a share. Again, migration of the derivative markets will take years and will be an ongoing process, but the desire of Treasury to move these instruments into the open framework of regulated marketplaces will surely boost the business and profitability of the CME for many years to come. As a long-term investment, I hardly think that CME shares have reached their best days.

While the profit models for the banks are getting more challenging in the new age of regulation, the exchanges are poised to benefit -- and deliver a great investment possibility to you and your portfolio.

Dan Dicker has been a floor trader at the New York Mercantile Exchange with more than 20 years' experience. He is a licensed commodities trade adviser. Dan's recognized energy market expertise includes active trading in crude oil, natural gas, unleaded gasoline and heating oil futures contracts; fundamental analysis including supply and demand statistics (DOE, EIA), CFTC trade reportage, volume and open interest; technical analysis including trend analysis, stochastics, Bollinger Bands, Elliot Wave theory, bar and tick charting and Japanese candlesticks; and trading expertise in outright, intermarket and intramarket spreads and cracks. Dan also designed and supervised the introduction of the new Nymex PJM electricity futures contract, launched in April 2003, which cleared more than 600,000 contracts last year alone. Its launch has been the basis of Nymex's resurgence in the clearing of power market contracts over the last three years. Dan Dicker has appeared as an energy analyst since 2002 with all the major financial news networks. He has lent his expertise in hundreds of live radio and television broadcasts as an analyst of the oil markets on CNBC, Bloomberg US and UK and CNNfn. Dan is the author of many energy articles published in Nymex and other trade journals. Dan obtained a bachelor of arts degree from the State University of New York at Stony Brook in 1982.