Forcing Banks to Spin off Swap Subsidiaries Will Hurt Liquidity & Goes Against Main Concepts of OTC Derivative Reform

The Senate proposal to spin-off derivative dealing desks from banks will be decided upon as we enter the final stretch of the long roadmap to complete the financial reform overhaul in the US. Over the next couple of weeks the House and Senate will enter into conference to reconcile the key differences between the Senate’s “Restoring the American Financial Stability Act of 2010,” passed last week, and Chairman Frank’s House Financial Services bill, passed all the way back in December of last year, and this issue will be a priority to resolve.

As a taxpayer and a voter, I can see the main street appeal to this proposal, but for market liquidity it’s a bad idea and also raises the question of whether the other main tenets of the reform will actually work.
Forcing the banks to spin off their derivative desks will most certainly mean fewer swap dealers to provide liquidity. Earlier in my career, I was part of a swap subsidiary in the heyday when banks created swap subsidiaries (Remember Sumitomo Cap, Fujii Cap, Sakura Financial Products, DKB Financial Products?). From capital to legal structure to getting credit ratings, it was costly to set up these subsidiaries. Sure the large swap dealers will do it if they have to, but the smaller swap dealer that has the corporate end-user relationship may opt not to bother.

Who would also own these swap dealer affiliates? Surely the banks that currently are in this business will invest the capital, so the risk to the bank is still there, but ultimately it will be capped to the balance sheet and leverage of the swap affiliate. Again, this has to limit the market making capacity of the dealer and should limit liquidity.

Aside from the liquidity issue, it contradicts the structure of the reform, from the benefits of clearing, margining and capital requirements to the concept behind the Volker rule. The margin requirements should cover counterparty risk from one day to the next. The additional capital requirements are supposed to control leverage, which was really the root cause of the financial crisis, not the derivative instruments themselves. Spinning off the swap subsidiaries also begs the question of who would ultimately regulate them as well. Interestingly, AIG’s separate swap subsidiary was AIGFP.

Already the banks are making their case, and Chairman Frank has already publicly stated that he doesn’t agree with this aspect of the Senate bill, so hopefully common sense will prevail during the reconciliation process over the next few weeks.