In a victory for banks, global financial regulators revised rules governing how much money must be set aside to cover losses by swaps traders, backing away from guidelines that firms warned would destabilize the $693 trillion derivatives market.
The Basel Committee on Banking Supervision's final rule, released today, would require swaps dealers to hold less cash to protect against defaults than did a proposal published last year. The plan now applies a minimum 20 percent risk weighting to money deposited at clearinghouses, which are third parties that guarantee the transactions, down from 1,250 percent in the original proposal. The change takes effect on Jan. 1, 2017.
The interim plan had threatened to boost costs as much as 92 times, according to calculations by three banks shared with Bloomberg News. The risk from that original rule, which was last revised in 2013, was the higher costs could have caused market participants to flee rather than take advantage of the clearinghouses, making it more difficult for the third parties to safeguard the swaps market.
"They really had people spending a year thinking about it, and they reversed it. The banks should be very happy," said Chris Cononico, president of GCSA LLC, a New York-based underwriter that's seeking to insure derivatives clearinghouses. The proposed rule "seems to have evaporated," he said.
International regulators are trying to safeguard trades and bring more openness to a market whose secrecy and sheer size overwhelmed regulators in 2008. Where swaps had been one-on-one deals before, now they would be backstopped by third parties in clearinghouses that ensure everyone can pay, with the aim of avoiding emergency bailouts and panic. Basel is made up of regulators from 27 of the world's largest economies and sets international bank supervisory guidelines.
Swaps are what investors use to help guard against risk. They're bought by pension plans and retirement funds to protect against fluctuations in interest rates, meaning they affect most people who own annuities. They're used by the U.S. government to limit exposure in the mortgage market and cut home-loan costs. Investors can also hedge an investment in a company by buying a swap that will pay them if a borrower stops paying its debts.
They're called swaps because investors and banks exchange, or swap, payments over time based on how interest rates move or how the creditworthiness of companies changes. They trade on swap execution facilities, including one run by Bloomberg LP, the parent of Bloomberg News. Other SEF owners include ICAP Plc and Tullett Prebon Plc.
The Basel committee had a fine line to walk. The lack of capital to back up losses in the private swaps market was the main reason why the U.S. bailed out American International Group Inc. in 2008, Michael Barr, a law professor at the University of Michigan, said before today's revision. Barr helped write the Dodd-Frank law, which aimed to make the U.S. financial system more transparent and resilient, when he served as an assistant Treasury secretary from 2009 to 2010. Taxpayers ultimately provided $182.3 billion in bailout funds to AIG, since repaid.
Clearinghouses can make trading safer by "clearing" trades -- collecting cash or collateral to ensure participants are able to pay their obligations. Clearinghouses deal only with member firms, which act as intermediaries for their customers. To cover losses and keep the market from being disrupted by deadbeats, clearinghouses also pool cash and securities from the member dealers in what they call default funds.
There's about $30 billion in default funds worldwide, GCSA's Cononico said. The largest swaps clearinghouse owners are exchanges: CME Group Inc., IntercontinentalExchange Group Inc., London Stock Exchange Group Plc and Deutsche Boerse AG.
The world's largest derivatives brokers at the end of 2013 were owned by Goldman Sachs Group Inc., JPMorgan Chase & Co., Newedge Group SA, Deutsche Bank AG, Morgan Stanley and the Merrill Lynch division of Bank of America Corp., according to the U.S. Commodity Futures Trading Commission.
The reversal by Basel is "not just a victory for the banks, it's a victory for the system," said Will Rhode, director of fixed-income research at New York-based Tabb Group LLC. By reducing the cost to clear trades, more banks will be able to offer clearinghouse services to their clients such as money managers and pension funds, he said. "That means more capacity for clearing will be there and the system won't be working at cross purposes."