As the Securities and Exchange Commission and Commodity Futures Trading Commission try to create rules governing the burgeoning $700 trillion over-the-counter derivatives market, buy-side firms want to ensure they aren't left out in the cold.
The most vocal advocate: the Managed Funds Association. The influential Washington, D.C., trade group representing the hedge fund industry wants fund managers to participate in centralized clearing and execute orders through swap exchange facilities on an equal footing with the big Wall Street wirehouses.
The goal: to prevent clearinghouses from favoring centralized clearing between swap dealers, leaving fund managers to process their trades on a bilateral basis. Fund managers believe those large banks want to keep as many swap contracts out of clearinghouses as possible because they earn more money if the deals are executed over the phone and not centrally cleared.
The risk committees of clearinghouses such as those operated by CME Group and ICE, will recommend which derivatives should be handled by the clearinghouses and which should be exempt. They will also decide how much collateral clearing members must put up as collateral to cover potential losses. Those clearing members-the large broker-dealers-will add their own margin requirements to whatever the clearinghouses want. Fund managers privately say that those risk committees are controlled by large banks such as JP Morgan, Morgan Stanley, Deutsche Bank, UBS and Citi, among others.
The European Commission is now investigating whether 16 of the world's largest broker-dealers and data provider Markit are abusing "their dominant position" to control the flow of financial information on credit default swaps. The EC also wants to know whether nine of those dealers are getting preferential fees from ICE Clear Europe, the European clearinghouse arm of ICE.
A March report issued by Swiss financial services firm UBS on how hedge funds and other institutional asset managers are reacting to reform in the OTC derivatives market, shows they feel an increased urgency to prepare to clear through a clearinghouse-a process otherwise known as centralized clearing. About 60% of those said they expected to begin clearing through a clearinghouse within the next six months at most.
"Most of our members are ready, willing and able to clear both current and future clearable swaps once certain basic impediments are addressed," said Richard Baker, president and chief executive officer of the MFA in a March 24 letter to the SEC. "However, there are substantial structural and economic barriers to full buy-side participation in central clearing." MFA officials declined to comment further.
Baker urged the CFTC and SEC to finalize rules on how clearinghouses and electronic trading facilities operate no later than July 15. That timetable would allow regulators to publish by Sept. 1, the list of contracts which must be cleared. By Dec. 31, fund managers should have signed the appropriate legal documents with clearing brokers and central clearinghouses to have an additional six months to test processing OTC derivatives through a clearinghouse. Clearing of all standardized contracts should be mandatory by July 1, 2012, says the MFA.
The MFA says that the lack of cooperation from broker-dealers and continuing regulatory uncertainty has prevented the two clearinghouses operated by CME Group and ICE to meet a long laundry list of essentials. Those include completing end-to-end production testing of front-, middle- and back-office processing to enable streamlined processing of trade information, cash flows and reports; defining the type of financial disclosure required for buy-side firms; ensuring buy-side representation on governance boards and clarifying the protocols for how trades are to be confirmed.
"We believe the proposed regulation should affirmatively mandate that the boards of security-based swap clearinghouses, exchanges and electronic trading facilities, risk committees and regulatory oversight committees include non-dealer customer representation," said Stuart Kaswell, general counsel to the MFA, in a letter to the SEC on Nov. 26, 2010. "In particular, we believe that it is critical that the Commission impose requirements that affirmatively limit the representation of clearing members on boards and committees to a percentage that is less than what would constitute control under the corporate constitutive documents applicable for the relevant board or committee."
The MFA's latest request: In an April 29 letter to the SEC, that trade group asked the regulator to ensure clearinghouses agree to "transparency and audit" of their policies; free public dissemination of end-of-day settlement prices; real-time submission of security-based swap transactions for clearing; and prohibit any discriminatory treatment of non-direct clearing members-aka fund managers. "We believe that when an indirect clearing participant trades with another indirect clearing participant, the clearing process should be identical and as prompt as when one of the parties is a direct clearing participant," Kaswell said.
Hedge funds, which now manage about $2 trillion in assets, often enter into interest rate and credit default swap contracts to mitigate risk and bet on outcomes. By industry estimates, they constitute at least 20% of daily trading in the OTC derivatives market. Pension plans, mutual funds and other institutional funds are also getting into the game. The letters written by groups such as the Investment Company Institute, TIAA-CREF and other so-called traditional fund managers indicate a similar stance to the MFA's.
Most interest rate, credit default and other swaps bought and sold by fund managers will need to be processed by a clearinghouse later this year, as part of the Dodd Frank Wall Street Reform Act, which tightens OTC derivatives regulation following the financial crisis. Clearable swap deals must be executed on an electronic trading venue.
The Dodd-Frank measure split up the responsibilities for overseeing the OTC derivatives market between the CFTC and SEC. Broadly speaking, the SEC is to take charge of policies related to security-based swaps such as credit default swaps, while the CFTC will be responsible for other contracts.
The CFTC and SEC have not finalized the ownership and governance policies of clearinghouses or swap execution facilities but have rolled out definitions of swaps that will be eligible to be centrally cleared and electronically traded. The CFTC has proposed that the collateral of a swap user only be tapped it that user goes bankrupt. It should not be used if another user defaults.
