Moody's Downgrade Threat Seen Driving Buy-Side Clearing
First Published Friday, 27th April 2012 08:45 pm - © 2012 Dow Jones
--Clearing may be accelerated if firms' ratings are cut
--Moody's action will be resolved by end of June
--Swaps users may stop trading with those rated below Baa
NEW YORK -- The specter of lower credit ratings for banks will encourage hedge funds and asset managers to push privately traded derivatives called "swaps" into clearinghouses, according to experts in the back-office plumbing for Wall Street.
They are worried enough about the potential creditworthiness of certain trading partners that might be subjected to downgrades by Moody's Investors Service, and they want the protection that clearing affords them, these people say.
This may accelerate a sea change in the way trades in the $700 trillion swaps market are processed. Pooling swaps into clearinghouses that guarantee the financial obligations of trading parties for a fee should help to mitigate risks building up in the financial system, analysts say, potentially bringing more safety to a market that was blamed for deepening the financial crisis.
The down side is that clearing will cost swaps users, and the banks that serve them, billions of dollars in fees when they already face higher costs of doing business under pending regulations, illiquid markets that are hurting their ability to trade in and out of positions, and frayed nerves from Europe's sovereign-debt crisis.
The firms would have had to clear trades later this year anyway when the 2010 Dodd-Frank financial overhaul law is set to take effect, making central clearing mandatory for financial firms using most types of swaps.
Firms that aren't dealer banks, which are called "buy-side" customers in Wall Street parlance, already were waiting for certainty over the time frame in which the mandate would be implemented. But the announcement by Moody's in February that it was considering lowering the credit ratings of 17 major banks--two of which already have been downgraded--has provided an impetus for clearing voluntarily sooner than the law demands it, experts say.
The review is on track to be complete by the end of June and firms may have to stop trading with dealer banks that have a low credit rating, typically seen as a rating below Baa.
"There was a false sense of calm, but the pending Moody's action and other concerns about counterparty credit risk management we believe are motivating people to clear in advance of the mandate," said Charley Cooper, a senior managing director at custody bank State Street Global Markets.
However, clearing is no panacea for risk. Craig Pirrong, professor of finance at the University of Houston, pointed out that clearinghouses are backed up by their members, who are dealer banks, so they too are at risk of failing and not offering guarantees in a severe market downturn.
"I am skeptical that, at the end of the day, clients will be able to run away from the big banks, or that clearing will substantially mitigate the risks decreased bank creditworthiness will create," he said. "Banks are so enmeshed in the system."
The Commodity Futures Trading Commission in the next few weeks is set to publish a list of swaps that will be subject to the mandate, according to people familiar with the matter. That will start a countdown to the clearing mandate that initially will affect banks, hedge funds and other firms active in swaps as of November, these people say. The CFTC declined to comment on this.
Banks separately acting as clearing agents for customers, on top of trading with them, are worried that they will need to start charging higher fees for their services on account of the new rules. Once the mandate is effective, it will be unlawful for a dealer to trade designated swaps, either with a customer or another dealer, without also clearing them. For dealers whose customers want to clear ahead of the mandate, they may have to facilitate that clearing as early as this summer, assuming the definition of what is a swap has been finalized by then.
After the mandate goes into effect, expected in August, there will be 90 days before the first wave of participants affected by the rules have to start clearing.
"For market participants trying to plan for a possible start date for mandatory clearing...it could be as early as this summer," said Gary Gensler, chairman of the CFTC, in a speech in March.
A private industry group of aspiring dealers and clearing brokers--called the Clearing Coalition--is actively lobbying the CFTC for certainty over the clearing-mandate deadline.
Somewhere between 60% and 80% of the swaps market, or $420 trillion to $560 trillion, is expected to be eligible for clearing. While trillions of swaps between dealers already are being cleared, less than $1 trillion of customer swaps are being cleared and mainly these are interest-rate swaps, according to independent research firm TABB Group.
Once Dodd-Frank is implemented the costs of clearing are expected to be cushioned by lower trading costs because the law says prices have to be displayed publicly soon after a trade is conducted. That price transparency will hurt banks' ability to charge their customers big margins on trades, helping to offset buyside clearing costs, but clearing in isolation early will be costly.
Previously, the cost of clearing trades for customers could be supported by fees that trading desks were able to charge. But under Dodd-Frank these businesses will have to be unbundled, forcing a rethink of the clearing-broker business model.
"It will drive fee structure changes," said J.R. Lowry, senior vice president of State Street Global Services. "The unbundling of execution and clearing will force firms to take a harder look at the value they get from their brokers."