Impact of the Derivative Reform on Costs: Transparency, Efficiency, Liquidity and Capital

As we begin to move toward the final stages of legislation on the OTC derivatives market, let’s re-examine some of the factors that will ultimately impact costs to End-Users, post reform.

There are areas where costs could increase under the reform and factors that could drive costs down:

Potential Cost Increases:

1.End-Users being required to post cash to cover margin costs to execute derivatives on an exchange or to the clearing firms to clear non-standard trades.

· Under all US proposals End-Users are exempt from this requirement.

2. Swap Dealers requiring cash collateral from End-Users to cover the margin costs they have clear their trades (whether exchange-traded standardized contracts or non-standardized contracts).

· Senator Lincoln’s bill has the strongest language to eliminate this risk to the End-User.

· HFSC’s and Dodd’s bills have it but more discretion by regulators to allow it.

3. Swap Dealers widening bid/offer spreads or charging fees to cover their increased cost of capital, which will go up and should be higher for un-cleared trades.

· No doubt capital charges are going up (see below for more).

4.Swap Dealers widening bid/offer spreads or charging fees to cover their increased cost for new, real-time regulatory reporting requirements.

· Probably minor in the grand scheme of things.

Offsetting End-User Benefits Under the Reform:

1. Derivative transparency increases and more people enter into swaps and costs go down.

2. Derivative execution efficiency increases and processing fees go down.

3. The safety of the now regulated derivative markets brings in new users and more liquidity, driving costs down.

So the big question is, will the key benefits outlined above outweigh the potential increased cost of capital that banks will be charged. This all of course depends on what that capital charge calculation is, and if Swap Dealers will actually pass it on. The Catch-22 is that because End-Users will not be required to trade on exchanges or be forced to clear, all End-Users transactions should be un-cleared. The reason for this is that a clearing firm needs to have a margin agreement with both parties in order to be able to function and cannot just have margin from Swap Dealers, as the mark-to-market position can go against the End-User. By default, then, capital charges will increase for Swap Dealers to enter into swaps with End-Users.

At the end of the day, the markets will determine how costs will increase or not. Some Swap Dealers may be willing to keep bid-offers the same to win or keep key clients or, if costs increase for un-cleared trades, End-Users may in the end decide it is more advantageous to exchange-trade their derivatives, if they can, or to opt at the end of the day to clear their trades or enter into collateral agreements with Swap Dealers to get a better price. The answer will be known a few years out through analysis of the derivative volumes and activity patterns, which, because of the reform’s repository requirements, should be real-time, accurate and transparent.