New Swaps Rules at a Glance
Derivative transactions come in a number of forms such as Interest Rate and Currency Swaps as well as Credit Default Swaps. The deals are designed to protect financial firms and other players in the swaps markets from fluctuations in interest rates, the value of currencies as well as the potential for default in consumer debt and mortgage loans.
But these deals can go south. In fact, the credit default swap game contributed to the financial crisis of 2008. Many of those deals were bets the big banks took on poorly performing mortgage backed securities that grew out of the sub-prime mortgage contagion.
So the CFTC was tasked with creating new swaps rules as part of the Dodd-Frank reform measure. Back in the day, many derivatives were traded exclusively in private. But now these deals will be processed through regulated trading platforms known as swap execution facilities. These platforms will help the Feds keep tabs on risky activity, much like a stock exchange.
The commodities watchdog will also require a wide array of these deals to clear through these platforms – more than the financial industry had hoped. The newly adopted “block trade rule” clarifies the types of trades that must pass through the swap execution facilities. Meanwhile some transactions will be exempt from this rule.
In particular, swap deals conducted by so-called commercial end users like airlines and agricultural companies. They rely on swaps as a hedge to protect against fluctuations in the currency and commodities markets. These are legitimate hedge transactions compared to the speculative trades conducted by large financial firms looking to make big bets in the hopes of making big money.
According to the New York Times Dealbook, CFTC head honcho Gary Gensler reportedly said “No longer will this be a closed, dark market.”
“I think what we’re planning to do tomorrow fulfills the Congressional mandate and the president’s commitment,” said Gensler.
How Will Big Banks Benefit from New Swaps Rules?
While there will be tighter regulatory control in the new scheme, the agency watered down a rule that will ultimately allow a few big banks to continue ruling the derivatives market.
And the players here include big banks like Goldman Sachs Group, Inc. (NYSE:GS), JPMorgan Chase & Co. (NYSE:JPM), and Morgan Stanley (NYSE:MS) among others.
Initially, the CFTC considered a requirement that asset management companies consult five banks when pricing a particular derivatives contract. The thinking was that this would lead to more competition among the big banks and therefore better pricing for the asset managers. But there was a strong push back by these leading financial firms and the agency lowered that requirement to only two banks. However, 15 months after the new rules are implemented the two bank requirement automatically goes up to three.
Because the derivatives market is a $700 trillion dollar game these key players will derive serious financial benefits. This is because they all will have a hand in creating and operating the swap execution facilities. Clearing deals through these platforms means these firms will garner profits from transaction fees. Moreover, these firms often serve as middle men in deals conducted by commercial end users where more fees will be scooped up.
So the financial titans will continue to have their fingers in big helpings of the derivatives pie. But the question remains as to whether or not this is the time to invest in the big banks again.
As for JPMorgan Chase & Co. (NYSE:JPM), CEO Jamie Dimon recently got a vote of confidence from shareholders as they decided not to split his dual roles as Chairman and CEO. But trying to determine what the value of shares will be as the financial sector continues to recover is not an easy task. Moreover, there are other regulatory and legal uncertainties on the horizon – in particular the ongoing Libor rigging probe.
Further, Goldman Sachs Group, Inc. (NYSE:GS) and Morgan Stanley (NYSE:MS) wrote down hundreds of billions of dollars of bad mortgage backed assets in the wake of the financial crisis. And their derivative transactions are not easy to value. While the two firms appear to have weathered the storm of the wave of legal actions that surfaced in the wake of the financial crisis, more unknown regulatory risk remains – like the Volcker Rule.
In short, investors considering the financial sector are probably better off looking at community banks that retain and service their mortgage portfolios and only rely on swaps as legitimate hedges.
The Bottom Line of the New Swaps Rules
The new rules will shed some light on the derivatives market and there will be tighter regulatory scrutiny of deals conducted on the swap execution facilities. And this could mitigate the chances of busted swap deals like the “synthetic credit default swap” blunder that caused a multi-billion dollar loss for JPMorgan Chase & Co. (NYSE:JPM) in 2012.
At the same time, leading financial firms historically find innovative ways to create new products and conduct different types of deals as new trading technologies emerge. So the new rules might work to mitigate the risks that led to the financial crisis of 2008. But it’s not the last financial crisis that matters, it’s the next one.
The article Big Banks Catch a Break on New Swaps Rules originally appeared on Fool.com and is written by Kyle Colona.
Kyle Colona is a freelance writer from the New York area with a broad background in legal and regulatory affairs in the finance sector. His extensive body of work is accessible on the web. Mr. Colona is not a financial adviser and he does not hold a position in the stocks mentioned herein. This article is for informational purposes only and should not be construed as financial advice.
The Motley Fool owns shares of JPMorgan Chase & Co. Kyle is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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