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Banks to cash in as U.S. derivatives reforms go live

A man walks past JP Morgan Chase's international headquarters on Park Avenue in New York July 13, 2012. REUTERS/Andrew Burton
A man walks past JP Morgan Chase's international headquarters on Park Avenue in New York July 13, 2012. REUTERS/Andrew Burton

By Douwe Miedema

WASHINGTON (Reuters) - Banks have been complaining bitterly about new laws to sort out their industry, even though they were blamed for playing a part in the credit meltdown. But this time round, new U.S. rules look set to help them.

Starting on Monday, hedge funds and other large investors must guide their trading in derivatives through traffic control centers known as clearinghouses.

This will mean hundreds of millions of dollars of new business for some of the largest investment banks, which will act as gatekeepers to the clearinghouses.

JP Morgan Chase & Co , Citigroup Inc , Barclays Plc , Deutsche Bank AG and others have built new trading systems specifically to handle this complicated process.

"We believe our volumes will continue to increase every month, or every quarter," said Ray Kahn, head of Barclays' over-the-counter clearing business.

Clearinghouses have guaranteed mundane bank payments for centuries, but now they will increase the safety of derivatives, the complex financial products that critics say helped cause the financial crisis.

So far, any clearing has been voluntary. Monday will mark the beginning of a dramatic increase, as hedge funds and other large investors such as insurance companies are rushing to meet a deadline to submit their trades to clearinghouses.

The process has had its problems.

One hedge fund found recently that it took 4.5 hours to put a trade through a clearinghouse, said a senior executive at a large international bank. Another trade did not get through the clearinghouse at all.

"For those kind of issues to be coming up now, 10 days before the requirement goes life, that is an indication that there's still some bugs to be worked out," said the banking executive, who requested anonymity.

Derivatives will also become more expensive because funds need to put up larger safety buffers, or collateral, which functions much in the same way as property does in a mortgage. The banks offer tools to help keep these costs down.

BRIGHT SPOT

The migration toward safer trading is the first tangible sign of massive shifts in the banking industry after U.S. President Barack Obama and other world leaders embarked on an overhaul of the rules for finance at a 2009 summit.

One of the two main prongs of the global regulatory agenda is to start policing the $630 trillion derivatives market, which mushroomed from the 1980s, when politicians were tearing down rules for the financial industry.

The clampdown has mainly been bad news for banks. Besides leading to higher costs, it has opened up the lucrative market to competitors such as exchange operators.

But clearing provides a rare upside for a handful of big banks. Industry estimates show that less than 10 percent of interest-rate swaps and credit default swaps executed between banks and their clients are currently being cleared.

JPMorgan is the only bank to say publicly what this means for its business: It forecast extra revenue of between $300 million to $500 million from derivatives clearing and related services over the next two to three years.

Other banks Reuters spoke to indicated similar levels. All expect a boost when the first wave of hedge funds has to start clearing four types of interest-rate swaps and two types of credit default swaps on Monday.

"We're actually seeing a lot of early adopters, pre-mandatory clearing," said Jon Hitchon, a senior manager in Deutsche Bank's clearing business. "Clients are anxious to test out the pipes and make sure they are compliant."

The Commodity Futures Trading Commission, the top U.S. derivatives regulator, has made clearing of these securities mandatory. It will gradually extend the requirement to all who trade them, and possibly to other products.

When dealing between each other, banks already clear the vast majority of derivatives. The big upside is in deals between banks and other users of derivatives: hedge funds, asset managers, insurance companies and pension funds.

Such investors use swaps to speculate on financial gains. The minority of companies that use them as a shield against swings in interest rates, foreign exchange rates, or other financial exposure are exempt from the rules.

RISKS REMAIN

Despite the new rules, the industry remains tightly held, and data is hard to come by. Only a handful of big Wall Street and European banks are meaningful gatekeepers to clearinghouses - or "clearing members" in industry parlance.

And the three major clearinghouses in the world function as near-monopolies.

LCH.Clearnet, which the London Stock Exchange is buying, clears 90 percent of bank-to-bank interest rate swaps.

The IntercontinentalExchange clears about 60 percent of the interbank volume in credit default swaps. CME , Chicago's powerful futures exchange, is the third big player, although it has a less dominant position.

The trading risk concentrated in these three companies is so big that they would threaten the viability of the financial system if they get in trouble. Regulators force them to keep high safety buffers to protect themselves against any mishaps.

Still, several people in the industry have expressed concern that the fight over new clients might lead them to compromise on the amount of safety buffers - or "initial margin" in industryspeak - that they need to put up.

"What we don't want to see is somebody lower their initial margin to attract customer business," said Chris Perkins, Citigroup's global head of derivatives clearing.

Another risk is that clients could stop using swaps altogether because the new rules have made them too expensive. That means it could take longer for the banks to make money and make it difficult for them to set pricing.

(Reporting by Douwe Miedema; Editing by Karey Van Hall and Lisa Von Ahn)

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