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A mighty wind is being unleashed on Capitol Hill… and it’s a welcome wind… kudos to House Agriculture Chairman Collin Peterson of Minnesota for proposing substantial new law to regulate the CDS space…

U.S. Draft Law Would Ban Most Credit-Default Swaps (Update1)

Jan. 28 (Bloomberg) — A draft bill circulated in Congress that would change how over-the-counter derivatives are regulated might ban most trading in the $29 trillion credit-default swap market.

House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota unveiled an updated draft bill today that would prohibit credit-default swap trading unless investors owned the underlying bonds. The draft, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the $684 trillion over-the-counter derivatives market to be processed by a clearinghouse.(THESE PRODUCTS MUST BE SETTLED ON A CENTRAL PLATFORM TO REDUCE SYSTEMIC RISK, ALLOW FOR OVERSIGHT BY REGULATORS AND ALLOW FOR REAL TRANSPARENT PRICING FOR  MARKET PARTICIPANTS)

“This would basically kill the single-name CDS market,” said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California. “Given the small size of many issuers’ bonds outstanding, this would make it practically impossible for the CDS market to exist.” (TOTALLY UNTRUE… THAT IS LIKE SAYING SMALL ISSUE STOCKS CANT TRADE ON THE NASDAQ OR NYSE… IT HAPPENS ALL THE TIME)

U.S. regulators and politicians are stepping up pressure on banks to use clearinghouses and agree to increased oversight of the OTC markets to improve transparency amid the credit crisis. Bad bets on credit-default swaps led to the U.S. takeover of American International Group Inc. in September. (HOW MANY 100 BILLIONS HAS THIS COST US?)

As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bonds, according to Eric Dinallo, superintendent of the New York Department of Insurance. Dinallo last year proposed outlawing so-called “naked” credit-default swap trading. He shelved the proposal in November because of progress by federal regulators on broader oversight of the market.

‘Bad Idea’

“It is reminiscent of the opposition in the 19th Century to futures trading in the belief that speculators were controlling the market and driving agricultural prices down,” said Robert Webb, a finance professor at the University of Virginia and a former CME trader. “This is a bad idea.” (THE ANALOGY MIGHT NOT BE CORRECT… WAS THE 19TH CENTURY FUTURES MARKET AS CONCENTRATED AS THE CDS MARKET IS NOW? WERE THERE SYSTEMIC INSTABILITIES THAT AROSE FROM FUTURES TRADING?)

Forcing interest-rate swaps and credit-default swaps through a clearinghouse, which would establish prices for the privately traded contracts, may reduce how much banks are able to make from them. (NO DOUBT MARGINS WILL DECLINE WHEN LIGHT IS BROUGHT INTO THIS SPACE… INVESTORS LIKE PENSION FUNDS, COLLEGE ENDOWMENTS, MUTUAL FUNDS WILL HAVE ACCESS TO BETTER PRICING INFORMATION)

As much as 40 percent of profit at Goldman Sachs Group Inc. and Morgan Stanleycomes from OTC derivatives trading, according to CreditSights Inc. Estimating the new income that exchanges such as CME Group Inc. could earn from processing the OTC trades is difficult because clearing fees and volumes aren’t set, said Bruce Weber, a finance professor at the London Business School. (THE PROFITS ARE VERY HIGH FOR THOSE WHO HAVE KEPT THIS MARKET DARK…NAMELY GOLDMAN SACHS AND MORGAN STANLEY)

Interest-Rate Swaps

JPMorgan Chase & Co. held $87.7 trillion of derivatives as of Sept. 30, more than twice as much as the next largest holder, Bank of America Corp., which had $38.7 trillion, according to datafrom the Office of the Comptroller of the Currency. Of the holdings at New York-based JPMorgan, 96 percent were in the OTC market, compared with 94 percent for Bank of America. (INTEREST RATE SWAPS ARE NOT AS DANGEROUS AS CREDIT DEFAULT SWAPS BUT SHOULD BE INCLUDED IN THE LEGISLATION IN SOME FORM)

The largest positions at JPMorgan and Bank of America, based in Charlotte, North Carolina, were in interest-rate swaps. Banks enter into interest-rate swaps with clients such as cities or hospitals that sold bonds and seek protection against adverse moves in interest rates. They also hedge their exposure to rates in the inter-dealer market. (INTERDEALER HEDGING IS PROBABLY THE BIGGEST VOLUME) 

The OCC data only included U.S. commercial banks, so Morgan Stanley and Goldman Sachs Group Inc. weren’t listed at the time. Both New York-based investment banks converted to banks regulated by the Federal Reserve on Sept. 21.

A provision in Peterson’s bill, which will be discussed in hearings next week, allows for the U.S. Commodity Futures Trading Commission to exempt certain OTC contracts that are too customized or don’t trade frequently enough to be cleared. (SET THRESHOLDS VERY LOW… IT’S NOT AS HARD AS THEY MAKE IT SOUND… DON’T LET THE BANK LOBBYISTS CONFUSE EVERYONE WITH TECHNICAL MUMBO JUMBO)

Adding Stability

Funded by its members, a clearinghouse adds stability to markets by becoming the buyer to every seller and the seller to every buyer. (YES)

The standardization necessary to process a contract in a clearinghouse, however, could harm the market and drive the trading overseas, Weber said. (NONSENSE… SAME ARGUEMENT MADE AGAINST GLASS STEAGELL AND LOOK WHERE WE ARE TODAY)

“It’s a big deal because the OTC market has developed almost as an alternative to the exchange market with its clearinghouses,” he said. “It would be advantageous for places like London, Hong Kong or Singapore where OTC trading wouldn’t have that kind of restriction.” (NONSENSE… IT’S LIKELY THOSE COUNTRIES WILL REGULATE THIS SPACE AS RIGOUSLY THEIR ECONOMIES ALMOST COLLAPSED TOO FROM THESE PRODUCTS)

Weber said that if price transparency is what Chairman Peterson wants, it can be achieved in other ways, such as putting OTC derivative prices on a system such as Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. (YES PUT THE PRICE REPORTING ON TRACE… I’VE BEEN ADVOCATING THIS… BUT PRICE TRANSPARENCY ALONE DOES NOT REMOVE SYSTEMIC RISK FROM WEAK COUNTERPARTIES WRITING TOO MANY CONTRACTS FOR CDS… THINK AIG)

Peterson’s draft bill would also authorize a study by the CFTC to determine if OTC trading influences prices on exchange- traded contracts such as oil. If the commission found such an influence it would be authorized to set limits on how the size of positions held by OTC traders. (STUDY AWAY… YOU MIGHT GET INTESTERING RESULTS)