Reforms to the $708 trillion private derivatives market are reducing systemic risk while some rules need more work before being implemented, said Stephen O’Connor, chairman of the International Swaps and Derivatives Association.
“There is today serious concern about some of the other policies underway” related to the Dodd Frank Act that toughens oversight of the market, O’Connor, Morgan Stanley’s global head of over-the-counter client clearing, said at ISDA’s annual meeting Tuesday in Chicago. He cited differences between new swaps rules in Europe and the U.S., known as extraterritoriality, and mandated electronic execution for swaps as issues the industry wants to address.
Banks, hedge funds and asset managers active in the over- the-counter derivatives market are adapting to changes mandated by the Dodd Frank Act passed by Congress in 2010, including a requirement to process most swaps with a clearinghouse to cut counterparty risk. While embracing measures to adopt clearing, the industry group has opposed requirements that any cleared swap be traded on exchanges or similar electronic systems.
“There’s little to suggest it will benefit users,” O’Connor said, referring to ISDA research that found that requiring electronic trading would reduce trading and increase the gap in prices to buy and sell swaps.
A proposal by the Commodity Futures Trading Commission that traders get a minimum of five price quotes before a transaction “needs further consideration,” O’Connor said. Many bank swaps customers “are opposed to this since excessive inquiry might itself stimulate an adverse price move,” he said.
The reforms are aimed at one of Wall Street’s largest profit centers. The largest dealers make a collective $30 billion a year by executing fixed-income swaps, such as for interest rate and credit risk, with their customers, compared with $3 billion to $5 billion a year from trading fixed-income futures, according to consulting firm Oliver Wyman.
“Trading has been an extremely profitable business for the banks,” Luigi Zingales, a professor of entrepreneurship and finance at the University of Chicago, said during a panel discussion at the conference. The small number of dealer banks that control the swaps market makes it difficult to have effective competition, he said.
“There is gigantic opposition to moving to more transparency” because it reduces profit margins, he said.
The Federal Reserve is tasked with monitoring the health of the economy, said Patrick Parkinson, the former director of the Fed’s Division of Banking Supervision and Regulation.
“Obviously the experience from 2007 and forward indicated none of us were completely successful,” he said. It was “completely understandable” that Congress created the stability council after regulators missed risks from American International Group Inc. and monoline insurers, he said.
Under a provision of Dodd Frank, the Financial Stability Oversight Council was created to monitor and identify risks to the U.S. financial system, including the Office of Financial Research. Recognizing large risks to the economy ahead of time is a challenge, said Lars Peter Hansen, a finance professor at the University of Chicago.
“Do we know how to do it yet? It’s not 100 percent clear we know how to define” systemic risk, he said during the panel discussion. He alluded to Potter Stewart, the U.S. Supreme Court justice, who defined pornography as something he knew when he saw it.
The CFTC has completed 100 rules out of a total 400 to cut risks in the market, O’Connor said. The industry lowered systemic risk by adopting clearing ahead of regulations and through collateral agreements that protect against counterparty losses, O’Connor said.
“ISDA strongly supports clearing requirements but wants to make sure the implementation is done right,” he said in opening remarks at the conference. “We don’t want to see a race to the bottom on margin terms,” or fragmentation of clearinghouses that will make the market less stable, he said.
Dodd Frank has made clearinghouses another entity that is too big to fail that includes a Federal Reserve option to lend to the central counterparties in times of stress, said Mark Brickell, chief executive officer of Blackbird Holdings Inc., which provides an electronic trading system for derivatives, and former chairman of ISDA.
“It is a great leap of faith” to increase the number of too big to fail institutions, he said during the panel discussion.
O’Connor was appointed as ISDA chairman a year ago, “a time of significant change in our markets and our firms,” he said. “Life as we know it will change.”
ISDA, the lobbying and industry group for swaps users, has more than 800 members in 58 countries, O’Connor said.
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