The $639 trillion over-the-counter derivatives market begins thelargest transformation in its 30-year history today with rulesintended to contain another financial crisis, trimming profits forWall Street banks.

Companies from JPMorgan Chase & Co. to BlackRock Inc. arenow required under the 2010 Dodd-Frank Act to have most of theirprivately negotiated swaps trades backed by a clearinghouse that'scapitalized by the world's largest banks. That means dealers andtheir customers have to post upfront collateral to absorb losses ifa firm defaults and settle daily losses.

Regulators are overhauling a market that complicated efforts tountangle the worst financial crisis since the Great Depression byobscuring how interconnected and vulnerable banks had become toeach other. Executives from at least three dealers are concernedthey may not be ready for a surge in cleared trades, while SanfordC. Bernstein & Co. said the rules may cut pre-tax margins atbank trading units by a third. Swaps helped produce a combined $30billion in annual profits at the biggest dealers, consulting firmOliver Wyman estimates.

“The shift to central clearing will transform the economics ofOTC derivatives,” said Bernstein's Brad Hintz, ranked byInstitutional Investor magazine as the second-best analyst coveringbrokerage firms and exchanges. “Trade volumes should increase, butthat increase is not going to offset the margin decline. WallStreet's derivative clients will be the winners.”

The rules may cost New York-based JPMorgan $1 billion to $2billion in revenue, the biggest U.S. derivatives dealer said in aFeb. 26 presentation. The bank will seek to reduce the loss withfees it can charge customers to help them trade, clear andcollateralize swaps, a business JPMorgan said may produce revenueof $300 million to $500 million by 2015.

The mandate this week also will be the biggest test of tradingand processing systems that banks have been building during thepast several years to comply with Dodd-Frank rules.

Executives who help oversee derivatives clearing at three ofWall Street's largest banks said they were worried that the systemsthey've connected to clients and clearinghouses aren't ready tohandle the trades. The executives spoke on the condition neitherthey nor their firms be identified so as not to upset clients.

Skipping Florida
Two ofthe executives said they aren't traveling to Boca Raton, Florida,this week for the Futures Industry Association annual conference sothey can be in New York in case problems occur.

Officials at two other major dealers said that while they aren'tworried about today's deadline, they are concerned their systemswill be stressed in June when a larger number of firms, includingbanks, insurance companies and smaller hedge funds, are required toclear their swaps trades.

Money managers such as New York-based BlackRock, the world'slargest asset manager, and Citadel LLC, the Chicago- basedhedge-fund and securities firm run by Kenneth Griffin, have beenvoluntarily clearing swaps trades before today's deadline atLCH.Clearnet Group Ltd., Intercontinental Exchange Inc. and CMEGroup Inc., which run the three largest clearinghouses for thederivatives.

In all, clearinghouses since 2009 have processed $24 trillion innotional value of trades between banks and their customers,according to the companies. Notional values don't represent theactual money that has changed hands and are used to determinepayment flows under swap contracts.

LCH.Clearnet, the world's largest interest-rate swapclearinghouse, accounts for more than $22 trillion of that total,the London-based company said last week. Intercontinental hasprocessed $160 billion in cleared customer credit-default swaps,according to Brookly McLaughlin, a spokeswoman for theAtlanta-based exchange.

Chicago-based CME Group, which doesn't break out trades betweena bank and its customer, lumping them in with contracts between twodealers, has processed $2 trillion, said spokeswoman LaurieBischel.

Wall Street's largest banks and money managers failed to fulfillcommitments made in 2010 to enable swaps customers to useclearinghouses to back trades, New York Federal Reserve BankPresident William Dudley said in 2011.

'On Board'
While the NewYork Fed prodded JPMorgan, Deutsche Bank AG, Goldman Sachs GroupInc. and other dealers into clearing more than 90 percent ofeligible inter-bank trades by the end of 2009, their clientsresisted on concern that the potential added costs would outweighbenefits.

“What's new here is clients are getting on board,” NiamhAlexander, an exchange analyst with KBW Inc. in New York, said in atelephone interview. She noted that dealers have been clearinginterest-rate swap trades among themselves at LCH.Clearnet since1999 and credit swaps at Intercontinental Exchange since 2009.

Credit-default swaps, used by investors to hedge against orspeculate on the ability of companies and governments to repaytheir debt, played a role in the financial crisis when they wereused to mimic mortgage-backed securities that plunged in value,spreading losses from the U.S. housing collapse across theglobe.

The unregulated market, in which former Fed Chairman AlanGreenspan in 2006 complained trades were often recorded on scrapsof paper, ballooned almost 100-fold within seven years to top $62trillion of contracts by the end of 2007, according to estimatesfrom the International Swaps & Derivatives Association.

That number has shrunk to about $24 trillion today, according todata from the Depository Trust & Clearing Corp., which beganpublishing information from its central swaps repository after theSeptember 2008 collapse of Lehman Brothers Holdings Inc.

The mandate taking effect today is the first in a series ofgovernment decisions on the types of swaps that must be settled atclearinghouses. The five-member Commodity Futures TradingCommission voted unanimously in November to require someinterest-rate and credit swaps to be the first trades under therequirement.

Credit Benchmarks

Rate swaps in four currencies — U.S. dollars, euros, Britishpounds and Japanese yen — must be cleared, as well as contracts onbenchmark credit-swaps indexes in North America. The CFTC on Feb.25 delayed the start of mandatory clearing for Markit iTraxxindexes tied to European companies.

“To move the largest number of swaps to required clearing in itsinitial determinations, the commission believes that it is prudentto focus on those swaps that have the highest market shares, and,accordingly, the biggest market impact,” the agency said in itsfinal determination.

JPMorgan and Goldman Sachs are among more than 70 registeredswap dealers, the first type of trading company that must meet therequirement. Other financial entities will face a June 10 deadline,while pensions and accounts managed by other asset managers willhave to start clearing trades Sept. 9. Commercial and manufacturingcompanies, so-called end-users of swaps, are exempt from therequirements under Dodd-Frank and CFTC regulations.

The agency expects this year to consider a clearing mandate forsome commodity and energy swaps, CFTC Chairman Gary Gensler said intestimony at a Feb. 14 Senate Banking Committee hearing.

Hedge funds and money managers that were trading swaps directlywith a number of banks prior to the clearing mandate should see areduction in their margin costs, said Peter Borish, the formerchief executive officer of commodities hedge fund Touradji CapitalManagement LP. While individual banks could lower marginrequirements for its customers if positions offset each other,investors typically spread their swap trading among severaldealers, he said.

With a clearinghouse, all positions are in one place, leading toan investor's entire portfolio being eligible for margin offsets,he said.

“I see that as a tremendous benefit,” said Borish, who was alsoa former head of research at hedge fund Tudor Investment Corp.

Elsewhere in credit markets, the extra yield investors demand tohold corporate bonds globally rather than government debenturesdeclined. The cost of protecting corporate bonds from default inthe U.S. reached a two-year low. Bond sales rose for the thirdweek. In emerging markets, relative yields narrowed for the firsttime in six weeks.

Global Spreads

Spreads on company bonds from the U.S. to Europe and Asiatightened 3 basis points to 144 basis points, or 1.44 percentagepoints, in the period ended March 8, according to Bank of AmericaMerrill Lynch's Global Corporate index, which reached 142 on Jan.10, the least since April 2010. Yields rose to 2.68 percent from2.61 percent on March 1.

The Barclays Global Aggregate Corporate Index has lost 0.88percent this month, bringing the decline since year-end to 1.86percent.

The Markit CDX North American Investment Grade Index, acredit-default swaps benchmark, fell 5.8 basis points last week toa mid-price of 80.6 basis points, the lowest since February 2011,according to prices compiled by Bloomberg..

The Markit iTraxx Europe Index of 125 companies withinvestment-grade ratings increased two basis points to 106 at 10:30a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asiaindex of 40 investment-grade borrowers outside Japan fell 1.25 to101.

The indexes typically fall as investor confidence improves andrise as it deteriorates. Credit swaps pay the buyer face value if aborrower fails to meet its obligations, less the value of thedefaulted debt. A basis point equals $1,000 annually on a swapprotecting $10 million of debt.

Bonds of Fairfield, Connecticut-based General Electric Co. werethe most actively traded dollar-denominated corporate securities bydealers last week, accounting for 3.1 percent of the volume oftrades of $1 million or more, according to Trace, the bond-pricereporting system of the Financial Industry RegulatoryAuthority.

Avon Products Inc. and Burlington Northern Santa Fe led $86.2billion of corporate bond sales worldwide last week, following$85.6 billion in the period ended March 1, Bloomberg data show.

Avon, the world's largest door-to-door cosmetics seller, raised$1.5 billion in a four-part bond sale that included its first30-year securities on record. Burlington Northern, the railroadthat Warren Buffett's Berkshire Hathaway Inc. bought in 2010, sold$1.5 billion of debt in its first offering in more than sixmonths.

In emerging markets, relative yields narrowed 11.1 basis pointsto 278.9 basis points, according to JPMorgan's EMBI Global index.The measure reached 245 on Jan. 3, the least since April 2010.

Bloomberg News

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