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Fed Seeks End to Wall Street Lock Over OTC Derivatives Market
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By Matthew Leising

May 6 (Bloomberg) -- The Federal Reserve is planning for the first time to break Wall Street’s hammerlock on so-called over-the-counter derivatives and bring more regulation to the $684 trillion market.

The central bank will require more transparency after the unregulated market contributed to the demise of Bear Stearns Cos. and Lehman Brothers Holdings Inc. and forced the government to use $182.5 billion to bail out American International Group Inc. The world’s biggest financial companies reported more than $1.3 trillion in losses and writedowns since the start of 2007, in part from derivatives, according to data compiled by Bloomberg.

The biggest sign of the Fed’s intentions came when Theo Lubke, the Federal Reserve Bank of New York official responsible for oversight of the market, said the biggest banks shouldn’t be allowed to dominate trading of the financial contracts, which let investors hedge against losses or speculate on everything from changes in interest rates to corporate defaults.

“It is simply unacceptable in today’s environment that the design and structure of the OTC derivatives market can be controlled by a handful of large dealers,” Lubke, a senior vice president at the New York Fed, said at an International Swaps and Derivatives Association conference in Beijing on April 22.

Lubke, 42, has pushed banks to speed up confirmation of trades and use clearinghouses for credit-default swaps to reduce the risk of failed transactions. He was appointed to police OTC derivatives in 2007 by Timothy Geithner, now Treasury Secretary, when he was president of the New York Fed.

Wake-Up Call

The comments were “a wake-up type of statement,” said Bruce Weber, a professor of finance at the London Business School. Banks have resisted changes to the OTC market because they want to limit competition, he said.

The Fed regulates bank holding companies, giving it oversight for some of the largest over-the-counter derivatives dealers. Lubke’s remarks at the derivatives industry’s annual meeting were made as a representative of the New York Fed. Lubke declined to elaborate on his comments.

“There is opacity in the OTC market that doesn’t have commensurate public policy benefits,” Lubke said at the conference. “This is not something that can continue.”

Robert Pickel, chief executive officer of ISDA, which represents dealers, hedge funds and other investors in the privately negotiated derivatives industry, said all types of financial companies deserve representation in the over-the- counter market.

Lehman, AIG

“In order to ensure participants have confidence in the operation of these markets, it’s important that they have a say in market developments,” Pickel said in an e-mailed statement.

Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

The U.S. government and the Fed have spent, lent or committed $12.8 trillion to stem the longest recession since the 1930s, which was triggered when credit markets froze in August 2007 after banks found they couldn’t determine the value of derivatives tied to subprime mortgages.

Over-the-counter derivatives, such as the $28 trillion credit-default swaps market, complicated U.S. and European efforts to unravel trades between banks. Bear Stearns was acquired by JPMorgan Chase & Co. last year, Lehman Brothers Holdings Inc. collapsed in the world’s biggest bankruptcy and AIG is selling assets after losses from derivatives. All are based in New York.

‘Transparent Manner’

Credit-default swaps are contracts that pay the buyer the face value of a bond or a loan in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. They are used to hedge against risks and to speculate on a company’s ability to repay debt.

“If this market is going to see its maturation into something that works for the benefit of the financial markets and participants as a whole, the arrangements of decision-making over key design elements need to be done in a more transparent manner,” Lubke told ISDA attendees. “That includes a broader range of market participants being involved in that process.”

The New York Fed got dealers to share power with investment firms by encouraging ISDA to appoint five buy-side firms including Pacific Investment Management Co. and Elliott Management Corp. to its committee that makes binding decisions on how credit-default swap contracts are settled. Previously only banks made those decisions.

Pimco is based in Newport Beach, California. ISDA and Elliott Management are based in New York.

JPMorgan Profits

New York-based JPMorgan is the largest user of over-the- counter derivatives, with $87.4 trillion in notional value last year, more than the next two largest, Bank of America Corp. and Citigroup Inc., combined, according to the Office for the Comptroller of the Currency. JPMorgan made $5 billion in profit from fixed-income over-the-counter trades last year, according to people familiar with the matter, who declined to be identified because the results aren’t public.

JPMorgan spokesman Brian Marchiony declined to discuss Lubke’s comments.

Capitalized by its members, a clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the default risk between parties to a trade. It also allows regulators to assess market positions and prices.

The New York Fed pushed last month for the world’s largest banks to offer hedge funds and other clients access to clearinghouses that back trades in credit-default swaps.

Dudley, Geithner

Intercontinental Exchange Inc. was first to back trades with its credit-default swap clearinghouse, ahead of rivals CME Group Inc. and NYSE Euronext. ICE Trust has guaranteed $257 billion of the contracts since March.

The New York Fed is concerned that credit-default swap clearinghouses lack a common feature of their counterparts for futures, allowing customers to segregate their trading from bank accounts.

“Banks and buy-side firms still need to make considerable improvements to both risk management and the design of the OTC derivatives markets,” New York Fed President William Dudley said April 1 in a statement.

Geithner said in March that the U.S. would for the first time regulate the market, and that clearinghouses for standardized products such as interest-rate swaps were needed to improve transparency.

The trading data will be made public so prices are more visible and the Fed will “encourage greater use of exchange- traded instruments,” Geithner said March 26 in Congressional testimony