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By Ronald Fink
Legislation that would require derivatives now traded over the counter to instead be handled by exchanges, or at least cleared by a central counterparty, would lower costs for companies using swaps to hedge risk, according to a paper released last week.
The paper by economist Robert Litan, a senior fellow at the Brookings Institution, noted that companies that use derivatives to hedge risk have told Congress that requiring OTC derivatives to move to exchanges or clearinghouses would increase their costs, and have thus sought and won exemptions under both the current House and Senate versions of financial reform legislation.
But the paper, entitled "The Derivative Dealers' Club and Derivatives Market Reform: A Guide for Policy Makers, Citizens and Other Interested Parties," insisted that requirements for exchange trading or at least central clearing are instead likely to reduce those companies' costs.
"As a matter of substance," Litan asserted, "the corporate end-users are wrong."
The economist explained that while banks currently require companies to put up little or no collateral for OTC swaps -- perhaps as a "loss leader" to gain other business from the buyers -- such a practice can end up costing buyers more if the contracts fail, as they did during the financial crisis.
"Current amounts of initial margin (to the extent that dealers impose them
on end-users) are generally too low," Litan wrote, "because they
do not take account of the externalities their failure may impose on the rest of the financial system (AIG being a classic case of this)."
Litan also said that the use of the OTC market results in unnecessarily large spreads between the bid and asked prices of such contracts, and that those spreads would shrink if the swaps were traded on exchanges or centrally cleared.
"End-users are paying higher implicit fees to dealers – in the form of larger
bid-ask spreads – for completing their derivatives trades than would be the case if standardized derivatives were generally cleared and eventually traded on exchanges, with greater price transparency," Litan wrote.
As a result, he added, "end-users as a group are likely to be better off, even with higher explicit margins, if there were no exemptions at all."
He conceded that there's a distinct likelihood that the five biggest dealers will undermine the benefits of moving to exchanges or central clearinghouses, since a consortium of those dealers controls the largest current clearinghouse through a company called ICE Trust. Goldman Sachs, JP Morgan Chase, Morgan Stanley, Citigroup and Bank of America account for more than 96 percent of the derivatives trades by the 25 largest banks, according to the Office of the Comptroller of the Currency.
But Litan, a former deputy assistant attorney general in the antitrust division of the Justice Department, called for antitrust action to force the divestiture of those ownership rights if the "derivatives club" threatens to dominate trading and clearing through its stake in ICE Trust.
"Competition in the market for clearing should be allowed to play out so that the market selects the most efficient competitor, if the clearing market proves to be a natural monopoly," he wrote. "If that competition is distorted by any abusive practices, those practices must be stopped, and if this cannot be effectively arranged, then structural remedies of the kind outlined here
should be implemented."
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