Last week, the battle over the future of over-the-counter (OTC) derivatives was joined in earnest.  FedFin concluded that the industry would be on the defensive when the Treasury, SEC and CFTC released their reform initiative last month (see Client Report DERIVATIVES10).  To be sure, the Senate Agriculture Committee isn’t banking’s best friend, but its hearing on the plan (see Client Report DERIVATIVES12) made clear that even those on the Hill hoping to help keep OTC over the counter have their work cut out for them.  Simply put, complex OTC structures – with credit default swaps (CDS) at the top of the list – have a long, hard slog before policy-makers remember that derivatives can be used for hedging, not just trading and speculative purposes.  The impact of AIG will take more than a while to wear off.  

When we initially analyzed the Administration’s reform initiative, we pointed to two critical parts:  the move from OTC to Central Counterparties (CCP) and exchange trading, along with tough new counterparty capital requirements.  The industry to date has largely focused on the first aspect of the proposal.  Recognizing that significant fee income is at risk if OTC instruments are pushed off the counter, it is arguing that too many contracts need to be customized to handle legitimate hedging purposes.  The Fed didn’t buy this, though, when the traders last week offered their own approach to market reform, with FRB-NY President Bill Dudley essentially telling them it was a nice try.  The central bank supports all the industry’s commitments to date, but wants a good deal more, he made clear.

One way the FRB and other regulators plan to get more is through sweet talk.  Along with supporting the Administration plan, the regulators are working on ways to get OTC trading to CCPs.  Not coincidentally, the banking agencies favor CCPs over exchanges, which fall under the CFTC not the bank regulators.  The OCC late last month released a critical interpretive letter in this arena (see FSM Report DERIVATIVES11).  It provides very substantial capital incentives for national banks to do their derivatives dealing with ICE Trust – a CCP which has signed up for FRB supervision.  The OCC makes clear in this ruling that the Fed’s role warranted the capital flexibility, signaling that it won’t look so mercifully on exchanges that aren’t subject to bank regulatory sanctions.

All this suits the banks fine – they get to trade on CCPs under rules they know even if they don’t exactly love them.  Much as the industry would like to keep everything OTC, CCPs are the lesser of two evils, especially if many derivatives can be considered customized and thus remain exempt from any centralized transaction structure.  Senate Ag sided as anticipated with the CFTC and wants exchanges, not CCPs.  This battle will wage on, but the odds so far are on the CFTC’s side because its allies on the Hill are moving forward while the banks and regulators are more than busy with all the other issues that preoccupy Senate Banking and House FinServ.  

However, the bank regulators – if not the banks – have an ace up their sleeve.  Even if Congress empowers exchanges, the Fed will then get them back under its wing.  As noted in FedFin’s previous forecast of the regulatory rewrite (see Client Reports in the REFORM series), the FRB is pushing for and will, we think, get authority to govern any settlement-and-clearing system it thinks systemically significant.  Count on it – any big derivatives clearing structure under the CFTC will get an added layer of Fed review under a new, Fed charter that pushes the ball right back to the CCPs, where the capital rules as noted make the grass greener for the banks.

Capital is king not only for the power struggle between CCPs and exchanges, but also with regard to the second issue we noted:  counterparty capital requirements.  This is an overlooked, but critical, part of the Treasury plan.  It brings much of the “shadow” banking system – big hedge funds for a start – under the bank regulators by proxy because regulated banks could only deal with capitalized trading partners.  

The new capital rules won’t come quickly – the agencies don’t want to add more strain to the very fragile situation made clear in the stress tests (see Client Report STRESS3).  Still, the rules are coming, regardless of what Congress does or doesn’t do with the bigger legislation revising the OTC market.  The legislation will, we think, advance in this session and pass in the next, but the capital standards will run a parallel course at the same time and drive at least as much market change all by themselves.