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The FT points up the complex, generally opaque politics of OTC derivatives regulation. It's not just that global finance has had a couple of decades to grow these businesses, which generate considerable profits. It's also the fact that much of this occurs outside regulation in a complex and shadowy private infrastructure that's already being shaken by maneuvering over credit default swap clearinghouses (this is a subject our own Donna Block has written extensively about; see her recent article in the May 4 issue of The Deal magazine). The FT points to some of these conflicts, notably between banks and exchanges, exchanges and clearinghouses, exchanges and interdealer brokers, the European Union and the U.S., and, indeed, everyone with everyone else. And, of course, floating out there and driving all this is the looming sense of a public interest in safe, transparent, efficient derivatives markets that emphasize productive hedging of risk over nonproductive speculation (though even that seemingly fundamental issue is infinitely more complex than it looks). The key players here are regulators and payments systems executives around the world, two groups that have long been deeply intertwined and, to the public, mostly invisible. The battlefield has two locales: in Congress and other legislative bodies around the world, but mostly in the arcane and cloistered arena of the standards setters and payments consortia. Standards here means not just product standards -- how do you define an interest rate swap for clearing and settlement -- but electronic, or digital standards, for communicating and disclosing information along the chain of interested parties: customers, brokers, dealers, utilities, regulators. If history in payments systems is any guide, technocrats quietly decide the winner of standards battles; legislators normally (well, always) lack the focus or expertise required for this very long-term and very technical game. And, of course, cross-border issues, which are key, will tend to default back to regulators and technocrats for resolution unless there's a huge public disaster. But if technical standards seem dry and mind-numbingly bureaucratic, they're really a cover for very serious power politicking. The stakes are high and the complexities of self-interest are intense. There's a general consensus that more derivatives volume needs to be pumped through "transparent" (the term is always relative) and regulated clearinghouses and exchanges. This will, most concede, tighten spreads on standardized derivatives, though defining what that standard will be involves the kind of nit-picking, if important, technical debate only tax law writers love. Who will get the business? Who will attract the kind of volume that, in turn, attracts more volume, creating the kind of network externalities that fuel consolidation and convergence in payments as much as, say, Internet search? Who will find themselves off the main highway of dealflow, and who will own the hot dog stand right next to the interstate exit? The politics here are complex. Take clearinghouses, which may become key hubs in derivatives clearing and settlement. Clearinghouses are usually owned by consortia consisting of either banks or other consortia; ownership and governance at the consortia level can get very intricate. Clearinghouses are engaged in the settling of accounts, as opposed to exchanges which generate prices. The IntercontinentalExchange Inc. (NYSE:ICE), which is building one of the CDS clearinghouses, has the backing of nine big banks and has gotten out ahead of its main U.S. rival, the CME Group Inc. (NASDAQ:CME), backed by hedge fund Citadel Group. The reason: a CME rule that forced customers to trade through the exchange, something ICE avoided. On the other hand, most exchanges, which used to be controlled by member firms, are now public, and they've been rapidly consolidating. As a result, while they get considerable order flow from the banks, they no longer control them. They have a little more wriggle room to seek out their self-interest. As the FT points out, the group most at risk appear to be interdealer brokers, like Icap, Tullett Prebon and a number of others, which as intermediaries between derivatives dealers could find themselves cut out by clearinghouses or exchanges. Not surprisingly, they're looking to buy into that burgeoning infrastructure, not just to retain order flow but also to get a say in shaping the system that evolves. A longstanding tension here also lurks between larger banks and smaller banks, or rather banks with big derivatives brokering and trading businesses and those that may want to service corporate clients with, say, hedging, but lack the infrastructure and expertise to make a lot of money at it. As the rules get written, as various standards get set, these two groups tend to be pitted against each other. Take the matter of customized derivatives, which Geithner left off the table. Customized means opaque, which means potentially high profit. The big banks will argue to keep them OTC. Smaller banks, which act as both customers and as facilitators for corporate customers, will tend to resist, arguing transparency and commoditized profits. The smaller or nonderivatives-broking banks (some of them are pretty big actually) may lack ownership clout within the various consortia, but, with their larger numbers, they may have more legislative impact. A final complexity: Much of the lobbying will occur through a flock of trade groups, from the International Swaps and Derivatives Association to the Wholesale Market Brokers Association to the Securities Industry and Financial Markets Association to the various bank associations, each of which has a different membership and will seek different ends. The political head-knocking will occur internally at their level first as they struggle to hone their messages based on their membership's self-interest. All this is incredibly fluid and will take a considerable amount of time to work itself out. At the end of the day, legislators may set the framework, but the system will evolve based on a variety of factors: which parties have the most clout with regulators and within the various payments consortia, and which systems prove to be most efficient and generate the greatest order flow. The big banks seem to have the greatest leverage right now, but who knows whether that will continue. Like nearly everything else in finance, the final shape of derivatives regulation will begin with a focus on safety and soundness and end up a matter of self-interest and efficiency. - Robert Teitelman See related story on Dealscape See story from The Deal magazine Robert Teitelman is the editor in chief of The Deal.
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Not surprisingly, the reaction to the Geithner principles on derivatives regulation was muted. The New York Times Friday has an op-ed by Frank Partnoy 
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Treasury Secretary Geithner is calling for new record-keeping requirements for what he calls "non-standard" derivatives. Part of the issue with the recordation of derivatives is that technology (e-mail, text message and so on) has made the formation of legally-binding contracts (such as derivatives) very cheap and easy. Efforts to promote better documenation on derivatives will provoke massive new campaigns to capture, archive and comprehend electronic financial records. See Details --Ben