Plans being floated on Capitol Hill to reform the opaque derivatives market are anxiously anticipated on Wall Street, and big banks are preparing ways to lessen the impact of whatever restraints emerge.
WASHINGTON ( TheStreet) -- Amid all the financial-reform chatter echoing through the halls of Congress, derivatives have been something of a whisper. But on the trading desks of Wall Street, the outcome is anxiously awaited, as big banks prepare strategies to lessen the impact of whatever regulatory restraints emerge. Derivatives layered additional risk onto a financial crisis of epic proportions. They led to the $180 billion bailout of American International Group ( AIG) -- or its big-bank counterparties, depending on one's point of view. Yet 18 months later, derivatives remain unregulated. They are also poorly understood -- by most agencies outside of the Federal Reserve, the politicians constructing the reform bill, and the taxpayers each hopes to serve. As part of a broad agenda for the financial industry, Congress has come up with two reform bills. Both assign regulators to the derivatives market, increase transparency and require higher capital margins. The proposals stand to make the industry less risky, but also less competitive and less profitable. Derivatives players are split on what to expect from the coming scrutiny: They either dismiss the rules as ineffective or fear the impending crackdown. Either way, they're planning to circumvent harsh regulation however possible.
The derivatives market is opaque, fraught with complexity and hard to define. Some derivatives are simple instruments used by corporations to hedge against currency, commodity or interest-rate risk. Others hedge against major swings in bond or equity prices. Still others, like credit default swaps, were designed to protect against default on pools of bonds or leases. They are tied closely to individual contract terms, making them more difficult to trade on an exchange. >>Nonfinancial Companies Impacted by Derivatives Legislation "They are designed to hedge idiosyncratic risk, rather than market risk," says Peter Vinella, a managing director at the consultancy LECG, who has worked in the derivatives market for over a decade. "Every one of these things is highly customized... It's not like you're trading a widget." While derivatives were designed to protect against market risk, there's no limit on who can own them, or for what purpose. A speculative trader can bet against a company's bond by purchasing CDS just as easily as a bond investor can buy the security to hedge against default. Layered on top of that are "synthetic" products, like synthetic CDOs, which are pools of CDS betting against pooled bonds. Banks and hedge funds have used such vehicles to make bets against broad swaths of assets, such as subprime real estate.