In an interview with the WSJ, Gary Gensler, Chairman of the Commodity Futures Trading Commission, said he believes the most critical change needed in the oversight of derivatives is the regulation of dealers involved in derivatives (see article). He goes on to say that "only through the dealer can we get the whole panoply" of information regarding derivative contracts. Such a move would require customized contracts traded over-the-counter (OTC) to go through a central repository, similar to an exchange clearing house.

Gensler believes that "central clearing will further lower risk," but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily. One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem. In the mean time, I guess at least the exchanges (NYX, NDAQ, CME) will be happy as the potential for increased order flow continues to rise.

While the effects of government bailouts and spending is still to be determined, Treasury Security Geithner does seem to be responsible for stimulating at least one industry - the exchanges. Since the announcement of his intent to shift more over-the-counter derivative trading onto the exchanges, the share price for the CME Group is up 27 percent, while the share price of Deutsche Borse (owner of the Eurex derivative exchange) is right behind, up 21 percent (see Financial Times article).

CME Group Daily Chart (1 year)
Source: Big Charts

In addition to the exchanges being able to trade more credit derivative products, such as credit default swaps, massive stimulus spending will also make it likely that demand will increase for interest rate products that are traded on the futures exchanges. In particular, the CME should do well given its trading in the popular Eurodollar contract. Yet, all is not rosy, as the introduction of new multilateral trading facilities will also require many of the existing exchanges to modify the way they currently do business, possibly also forcing a cut in fees. The "final" proposed regulations will also have to be carefully examined. For instance, if CDS trading is limited to only those with a direct interest, as opposed to third party speculators, then liquidity will be a fraction of what it is expected, offering less benefit to the exchanges. If, on the other hand, regulations are less restrictive, which seems necessary in order to maintain some type of relatively efficient and liquid market, then the exchanges will certainly benefit from the increased volume, even with a slight reductions in fees. Any rebound in the economy, or continuation of the current new bull / existing bear market rally will also have investors once again dreaming of $700 CME quotes. Let's hope so. After all, an increase in trading and retail participation in the market would certainly be good for more stocks than just the CME Group.

New draft legislation in Congress is considering two key changes to the CDS market (see Bloomberg article). First, the bill would require that all trading in the over-the-counter derivatives market would have to be processed by a clearinghouse. Second, the draft legislation would ban CDS (Credit Default Swap) trading unless investors owned the underlying bonds. While the CME group, ICE, and other exchanges would certainly cheer the first move, the second could make any added revenue streams disappear.

Given the size of many of the outstanding bonds, the single-name CDS market would have a difficult time existing. At a time when many markets are frozen, eliminating speculation does not seem to be the best course of action for a market that is currently suffering from liquidity issues. Surely, other measures can be taken to curb speculation (such has been done in the futures market with position limits) without further limiting liquidity and price discovery.

While utilizing a clearinghouse would help to define prices in the OTC market (certainly not welcomed news for the investment banks), and seems to make perfect sense, doing so would require some level of standardization. Some worry that a "non-standard CDS" market will still exist, with the proposed legislation simply forcing such trading outside of the US. While this not only forfeits a potential revenue stream for some US exchanges, it may also give up the ability of US regulators to have a say on how this market operates, which also seems counterproductive to the spirit of the draft legislation.