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 Now that the Treasury Department, Securities and Exchange Commission and Commodities Futures Trading Commission are asking for (and likely to get) regulatory authority of the over-the-counter derivatives market, what will participants in what is currently a largely unregulated market do now? (Deal Pipeline can see the full story here.)Given what global financial firms have become and the speed of technology, it's not a far-fetched idea that large OTC dealers like J.P. Morgan Chase & Co. (NYSE:JPM) or Citigroup Inc. (NYSE:C) could simply offshore the business to more friendly places. Robert Claassen, a partner at Paul, Hastings, Janofsky & Walker LLP, told The Deal last December that "if there's too much regulation or if all over-the-counter derivatives are forced onto an exchange ... the effect of that could be to drive the OTC market offshore. There are a number of credit default swaps currently booked in London, in Asia and it's possible to even do the transactions in places like the Caymen Islands." (See video below.) The International Swaps and Derivatives Association's CEO Robert Pickel echoed those sentiments at a conference on credit default swaps in December, saying "the rapid rate of CDS growth is driving a great deal of the regulatory interest in the market, but these products are very fluid and can be traded anywhere, so it's important that domestic regulatory actions take international concerns into account." The movement of the $600 trillion market from the U.S. abroad is a major concern for the ISDA and likely for the Treasury as well. Regulation such as Sarbanes-Oxley is often accused of making IPOs onerous enough that activity in that market headed overseas even before the financial crisis began. At the heart of the push for regulation are credit default swaps. While Treasury Secretary Timothy Geithner wants authority over the entire markets, it's the much-maligned credit default swaps and the specter of counterparty risk that have brought calls for regulation. Credit default swaps act like an insurance policy against a borrower defaulting on debt payments. The swaps have recently been accused of prompting bondholders to shun signing on to restructurings in a number of companies, since payoffs on the CDSs would allow them to recoup their investment when the company fell into bankruptcy. And with many companies expected to need restructuring of their debt loads in coming years, regulators see the issue looming large. But even more important is the systemic threat that credit default swaps may pose. Without a clearinghouse to provide guarantee of payment upon a credit event, buyers of the swaps can't be sure the sellers have enough money to pay off all the contracts they have written in the event of the failure of a major financial institution. American International Group Inc. (NYSE:AIG) has been bailed out three time because regulators fear its failure would start a cascade of additional failures throughout the system when AIG was unable to honor the CDS contracts it's written and other dealers found themselves unable to pay off on a rapidly increasing number of default contracts. If the regulatory framework set up drains the counter-party risk from the system, credit default swap contracts could not only remain primarily in the U.S., but also draw off some of the international volume. For the time being, the industry's advocacy groups -- the ISDA, the Counterparty Risk Management Policy Group III and the Securities Industry and Financial Markets Association -- are taking a wait and see approach, preferring to press their case with regulators rather than publicly as they have long expected some sort of regulation to come. In a press statement Wednesday the ISDA said: "This proposal is an important step toward much-needed reform of financial industry regulation," said Pickel. He continued: "ISDA welcomes the recognition of industry measures to safeguard smooth functioning of privately negotiated derivatives and looks forward to working with policymakers to ensure these reforms help preserve the widespread availability of swaps and other important risk management tools." But to give some insight into the ISDA's thinking, Pickel also commented at a conference on credit default swaps last December: "We know that credit default swaps will be part of the regulatory reforms that will begin in earnest next year. As we move into the regulatory debate, we should avoid a piecemeal approach and take a holistic look at addressing issues in the market." Looks like he may get his wish. - George White
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