Wall Street Braces for Derivatives Reform

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 Market

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.

The market is dominated by a handful of major players: JPMorgan Chase ( JPM), Bank of America ( BAC), Citigroup ( C), Goldman Sachs ( GS) and Morgan Stanley ( MS) control 97% of the market, according to the Comptroller of the Currency. A handful of insurers, including AIG, GMAC's ResCap subsidiary, and others like Ambac ( ABK), MBIA ( MBI) and Assured Guaranty ( AGO) have dominated the other end of the trade.

But while risk is concentrated in that respect, the $212.8 trillion derivatives market touches thousands of individual counterparties. Deals range from a simple hedge against a surge in oil prices, to an exotic CDO backed by swaps that protect against default on thousands of corporate bonds. As a result, the most convincing argument against the current proposal may be that the derivatives market is too complex to be so neatly managed.

"I don't think they're going to be able to 1) implement it or 2) create a situation where the number of derivatives players don't just go offshore," Vinella says. "There were billions and billions and billions worth of synthetic CDOs that were bundled pools of CDS contracts that were based on thousands of loans. Are you going to put that on an exchange?"

The Reform and the Politics

Most derivative deals are now negotiated "over the counter," with brokers negotiating prices for clients directly with an insurer. Under a Senate proposal, derivatives would have to either trade openly on an exchange with central clearing, or post higher margins for deals done in the dark. The Securities and Exchange Commission and Commodity Futures Trading Commission would share responsibility for oversight, and collect and distribute market data accordingly. A bill that passed through the House in December is similar, but slightly less robust.

The main worry among participants is that common end-users will face higher costs, while liquidity will be sapped from the exotic realm of the market. The only party that stands to benefit from mandated exchange-trading -- exchanges -- are also worried that volumes will decline enough to offset any gains.

Republicans and the bank lobby are digging in their heels for a fight. Yet, as KBW analyst Niamh Alexander puts it, "the train has left the station," for reform.

Vinella's attitude may capture the most challenging part of the effort, and the most dangerous outcome as well.

As a derivatives-guru-turned-consultant, he has spent years dealing with regulators he views as incompetent and legislators he views as dishonest and self-interested. He tells one story of receiving contradictory orders from regulators while managing a trading desk, and being tempted to disregard all of them, because he was certain no one would notice anyway. He tells another about a lawmaker who criticized his testimony regarding bank CEOs, then gave a wink and a nod after the meeting, saying those same CEOs had bankrolled his campaign.

While it may be unfair to view all of Washington's reform efforts as corrupt, the financial industry's influence is hard to ignore.

As midterm elections approach, financial firms are once again leading the charge in campaign donations. When combining all areas of finance that have a stake in derivatives reform, the total nears $50 million through Feb. 21 alone, according to the Center for Responsive Politics . That's far more than the "top" contributor, the law industry, which came in at just under $27 million.

Legislators receiving the most money from the financial sector are perhaps unsurprising. There's Chris Dodd (D., Conn.), who chairs the Senate Banking Committee, and drafted the reform proposal, as well as his Republican counterpart, Richard Shelby. Charles Schumer (D., N.Y.) who is also a key negotiator in reform efforts, is up there as well.

However, Dodd will be retiring this fall. He would like to pass a comprehensive bill to restore his legacy as a champion of financial reform, after the embarrassing disclosure that he had received a special mortgage from the former CEO of Countrywide Financial.

"A cynic might say the political benefits of finding a small and flamboyant group of scapegoats is hard to pass up when the alternative is constantly reminding the American public that it borrowed too much money," says John Williams, a partner at Allen & Overy who specializes in derivatives.

The Arbitrage Game

With Dodd's impending retirement, President Obama's reform agenda, a Democratic majority, and the public's disgust with Wall Street, a cooperative measure appears unlikely to emerge. As a result, the banking industry has been developing ways to mitigate the impact of potential rules almost as much as it's been trying to thwart them.

"Not a day goes by that I don't work on something dealing with this," says a key derivatives lawyer at a top bank, who was not authorized to speak on the record.

The opportunity for regulatory arbitrage seems ripe: Critis say the SEC and CFTC would be an ineffective regulatory team at best, and an antagoonistic one at worst. It's unclear how the Fed -- the main banking regulator with the most knowledge about derivatives -- will tie in.

Once rules are clearly defined, market participants suggest that they may avoid harsh requirements by repackaging derivatives into other types of instruments or devising new structures entirely. Some banks and hedge funds also warn that if the U.S. goes too far, they'll simply relocate derivatives operations offshore. For instance, while Europe is leaning toward mandated clearing -- which U.S. banks are already doing -- it won't necessarily mandate exchange trading. There are major trading hubs outside the West as well, like Tokyo or Hong Kong.

"This is as global a business as there is," says the bank lawyer.

Nonetheless, he views arbitrage threats largely as bluster, and doesn't see an easy way out of impending regulation. He and other insiders acknowledge that there are costs and risks associated with any such strategies, whether or not regulators are paying attention.

"You can't underestimate the ability of the Street to circumvent what's regulated," says Paul Zubulake, a senior analyst at Aite Group who works closely with exchanges, brokers and other derivatives players. "But that's like their threat: 'We're going to do this; we're going to do that.' But guess what? You're going to go down that road again?"

Perhaps the most earnest complaint about potential legislation, and the most legitimate fear, is that while derivatives may have exacerbated the crisis, they weren't the underlying cause. If the policy approach is misdirected, or put into the hands of an incompetent agency, problems will start sprouting up as soon as the last ones have been forgotten.

"We're not trying to be Dr. Evil and Austin Powers," says Vinella. "We're just a bunch of guys looking at mathematical relationships and trying to find inefficiencies and make a profit from it. I think it's the people who don't understand these contracts that you have to be worried about."

-- Written by Lauren Tara LaCapra in New York.

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