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.