The week of April 26th 2010 will be important for the future of derivatives and where those type of instruments may be legally transacted in the financial services industry. At the start of the week, it appears that the Senate bill will force commercial and investment banks to spin off those divisions that transact in derivatives into separate companies that will not have access to either FDIC deposit insurance or emergency borrowings from the Federal Reserve.
If passed into law, this proposal will dramatically change the securities industry in several ways. Derivatives have long been one of the most profitable areas of the securities business. Hence, by definition, the remaining portion of the securities firms will be less profitable. It is an open question about how much the valuation of financial institutions with securities businesses should be adjusted downward.
Second, derivatives are critical risk management tool(s), particularly in the management of physical commodities where both future supply and demand are uncertain. Apparently, there will be a narrow exception for "end users" — producers, manufacturers, and other companies that are not financial players who used derivatives to hedge. The proposed legislation will require exchange trading, with margining, with clearing and a number of other provisions that provide reasonable safeguards. However, whether it makes sense to restrict a major source of capital liquidity to the derivatives markets remains open.
Third, one of the main reasons credit default swaps ("CDS") first caught on in the interest rate markets was the ability for the first time to effectively 'short' a particular credit. Previously, it was virtually impossible to short a bond and then to borrow it to cover the 'short sale'. The introduction of CDS led to much better price transparency in the credit markets. CDS contracts also became an effective tool in the management of credit portfolios, both on the investor 'buy-side' and dealer 'sell-side' of the credit interest rate markets. Preventing security dealers from using CDS will likely lead to reduced liquidity, profitability and size of the credit trading businesses at major securities firms.
Toomre Capital Markets LLC ("TCM") hopes that the provision to spin-off derivatives units of securities firms fails to pass in the legislative process. There is an open question about what to do about the many derivatives contracts that are outstanding. Should they be moved to clearing houses where collateral will need to be posted or should just new contracts going forward be subject to the clearing house and collateral posting requirements? Good arguments can be made on both sides.
However, artificially separating derivatives from a major source of liquidity capital does not make sense. The forthcoming tussles over derivatives in the U.S. Congress will be well worth watching and understanding. Clearly the derivatives playing field will be changing. The question is how and what will the consequences be.