Swaps D-Day to Trim Dealer Profits

Move to clearinghouses means dealers have to post collateral.

The $639 trillion over-the-counter derivatives market begins the largest transformation in its 30-year history today with rules intended to contain another financial crisis, trimming profits for Wall Street banks.

Companies from JPMorgan Chase & Co. to BlackRock Inc. are now required under the 2010 Dodd-Frank Act to have most of their privately negotiated swaps trades backed by a clearinghouse that’s capitalized by the world’s largest banks. That means dealers and their customers have to post upfront collateral to absorb losses if a firm defaults and settle daily losses.

Regulators are overhauling a market that complicated efforts to untangle the worst financial crisis since the Great Depression by obscuring how interconnected and vulnerable banks had become to each other. Executives from at least three dealers are concerned they may not be ready for a surge in cleared trades, while Sanford C. Bernstein & Co. said the rules may cut pre-tax margins at bank trading units by a third. Swaps helped produce a combined $30 billion in annual profits at the biggest dealers, consulting firm Oliver Wyman estimates.

“The shift to central clearing will transform the economics of OTC derivatives,” said Bernstein’s Brad Hintz, ranked by Institutional Investor magazine as the second-best analyst covering brokerage firms and exchanges. “Trade volumes should increase, but that increase is not going to offset the margin decline. Wall Street’s derivative clients will be the winners.”

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

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

Executives who help oversee derivatives clearing at three of Wall Street’s largest banks said they were worried that the systems they’ve connected to clients and clearinghouses aren’t ready to handle the trades. The executives spoke on the condition neither they nor their firms be identified so as not to upset clients.


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

Officials at two other major dealers said that while they aren’t worried about today’s deadline, they are concerned their systems will be stressed in June when a larger number of firms, including banks, insurance companies and smaller hedge funds, are required to clear their swaps trades.

Money managers such as New York-based BlackRock, the world’s largest asset manager, and Citadel LLC, the Chicago- based hedge-fund and securities firm run by Kenneth Griffin, have been voluntarily clearing swaps trades before today’s deadline at LCH.Clearnet Group Ltd., Intercontinental Exchange Inc. and CME Group Inc., which run the three largest clearinghouses for the derivatives.

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

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

Chicago-based CME Group, which doesn’t break out trades between a bank and its customer, lumping them in with contracts between two dealers, has processed $2 trillion, said spokeswoman Laurie Bischel.

Wall Street’s largest banks and money managers failed to fulfill commitments made in 2010 to enable swaps customers to use clearinghouses to back trades, New York Federal Reserve Bank President William Dudley said in 2011.


‘On Board’
While the New York Fed prodded JPMorgan, Deutsche Bank AG, Goldman Sachs Group Inc. and other dealers into clearing more than 90 percent of eligible inter-bank trades by the end of 2009, their clients resisted on concern that the potential added costs would outweigh benefits.

“What’s new here is clients are getting on board,” Niamh Alexander, an exchange analyst with KBW Inc. in New York, said in a telephone interview. She noted that dealers have been clearing interest-rate swap trades among themselves at LCH.Clearnet since 1999 and credit swaps at Intercontinental Exchange since 2009.

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

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

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

The mandate taking effect today is the first in a series of government decisions on the types of swaps that must be settled at clearinghouses. The five-member Commodity Futures Trading Commission voted unanimously in November to require some interest-rate and credit swaps to be the first trades under the requirement.


Credit Benchmarks

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

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

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

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

Hedge funds and money managers that were trading swaps directly with a number of banks prior to the clearing mandate should see a reduction in their margin costs, said Peter Borish, the former chief executive officer of commodities hedge fund Touradji Capital Management LP. While individual banks could lower margin requirements for its customers if positions offset each other, investors typically spread their swap trading among several dealers, he said.

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

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

Elsewhere in credit markets, the extra yield investors demand to hold corporate bonds globally rather than government debentures declined. The cost of protecting corporate bonds from default in the U.S. reached a two-year low. Bond sales rose for the third week. In emerging markets, relative yields narrowed for the first time in six weeks.


Global Spreads

Spreads on company bonds from the U.S. to Europe and Asia tightened 3 basis points to 144 basis points, or 1.44 percentage points, in the period ended March 8, according to Bank of America Merrill Lynch’s Global Corporate index, which reached 142 on Jan. 10, the least since April 2010. Yields rose to 2.68 percent from 2.61 percent on March 1.

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

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark, fell 5.8 basis points last week to a 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 with investment-grade ratings increased two basis points to 106 at 10:30 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan fell 1.25 to 101.

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

Bonds of Fairfield, Connecticut-based General Electric Co. were the most actively traded dollar-denominated corporate securities by dealers last week, accounting for 3.1 percent of the volume of trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Avon Products Inc. and Burlington Northern Santa Fe led $86.2 billion 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 first 30-year securities on record. Burlington Northern, the railroad that Warren Buffett’s Berkshire Hathaway Inc. bought in 2010, sold $1.5 billion of debt in its first offering in more than six months.

In emerging markets, relative yields narrowed 11.1 basis points to 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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