Bill might hamper hedging tools

The proposed legislative overhaul of over-the-counter derivatives markets might deprive institutional investors of some valuable customized hedging tools or could shift the U.S. OTC business offshore.

The House Agriculture Committee on Feb. 12 approved the Derivatives Markets Transparency and Accountability Act of 2009, a bill introduced by its chairman, Rep. Collin Peterson, D-Minn. Among its 15 total provisions, the bill would require all OTC trades to be centrally cleared to solve counterparty risk, a major concern during the credit crisis.

“Anything that is not a standard product would be very difficult to clear,” Kevin Kearns, portfolio manager and senior derivative strategist at Loomis, Sayles & Co. in Boston, said in an interview. The firm has $120 billion in assets under management.

If the legislation is passed, it would mark the end of myriad OTC contracts too illiquid to be standardized and cleared. Investors who still want custom-tailored contracts would have to turn to a less regulated financial center abroad as had happened to initial public offerings under the Sarbanes-Oxley Act.

“London or another financial hub would become the center of all these types of products, because there are multiple reasons why investors want those products for hedging purposes,” Mr. Kearns added.

Such a law would be a blow to Wall Street's bottom line where, according to industry estimates, OTC-related fees and services account for about 40% of profits.

The push to solve counterparty risk via central clearing began last year with a focus on credit default swaps, which regulators feared could be the next source of systemic default. With a current notional value of $28 trillion, the CDS market represents only a fraction of all OTC derivatives, which had a notional value of $684 trillion as of June 30, the most recent data available.

“It has been an unregulated (OTC) market and this did contribute to the problem,” said Scott McDonald, head of research and senior managing director at Aladdin Capital Management, Stamford, Conn., which has $16.5 billion under management.

“I don't know if you can say whether this (CDS market) was the main factor or one of the factors contributing to the economic mess, but, if you go to this idea of a clearinghouse, you create a greater sense of security for investors. Obviously, we'll be clearing the most liquid items first.”

In short, there is a risk that strict U.S. regulations could confine hedging activity to exchanges alone.

“There is a tension right now between how to placate the constituencies that are mad at the mess we are and, at the same time, not taking away instruments that are very valuable. We hope that we don't swing so far as to limit the ability to manage risk,” said Jason Ungar, managing director at Gresham Investment Management LLC, a New York firm with $3.5 billion under management, mostly in commodities.

Although it is too early to tell how far OTC legislation will go because it is expected to be subjected to a vigorous debate, market participants see increased control as unavoidable.

“There is going to be a change in industry practices as it relates to government-sponsored or independent clearinghouses for CDS and other OTC derivatives with a flight toward exchange-based products as a result of what has happened in the market in the past six to 12 months,” said Eric Bernstein, North American chief operating officer at Sophis SA, a Paris-based global technology company specializing in portfolio and risk management software.

A survey of institutional investors released by Sophis Feb. 2 indicated 62% of respondents anticipated decreased use of OTC derivatives and more exchange-listed contracts over the coming months.

Mr. Peterson's bill covers a lot of ground. It wants to give the Commodity Futures Trading Commission the authority, with the president's consent, to suspend “naked” credit default swaps under some circumstances; close the “London loophole” by requiring foreign futures exchanges to adopt position limits for contracts similar to the ones traded on U.S. exchanges; ask the CFTC instead of the exchanges to set trading limits for physical commodities; limit hedge exemptions to offset actual contracts; and require the CFTC to report the position of index funds and swap dealers in agriculture and energy markets.

Overall, the changes would benefit exchanges and their clearinghouses because OTC clearing would increase their revenues.

“The exchanges have proven they have a good margining system with proper transparency, which the OTC markets did not have,” said Jack Hansen, chief investment officer at The Clifton Group, Edina, Minn., a money manager with $16 billion in assets under management.

But the strongest warning about the negative consequences of overly stringent rules comes from CME Group Inc., Chicago, a player that might have the most to gain from the changes.

CME executives are concerned that, by limiting the ability of speculators to hedge their own positions, the speculators would stop writing up the insurance contracts that investors need to protect their positions. Though they declined interviews, CME executives made their views clear about the risk attached to overregulating.

“The legislation imposes artificial constraints on the definition of hedge transactions that will impair OTC dealers from facilitating more complex hedging transactions and hedging their own net exposures,” the CME said in a statement in reaction to Mr. Peterson's bill. “The mandatory clearing of virtually all OTC derivative contracts will drive a significant portion of OTC business offshore, lessening the regulatory effectiveness of the CFTC.”

Mr. Peterson's bill is now headed to the House Financial Services Committee, chaired Rep. Barney Frank, D-Mass., who is mulling the creation of a “super-regulator” whose powers and regulatory goals are yet to be defined.