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The Golden Age of Derivatives


Era draws to a close.


Following his speech at the Economics Club of New York yesterday, Tim Geithner, President of the New York Federal Reserve, convened a meeting of the top derivatives firms in the world. For those of you wondering who the "Under the Fed Umbrella Club," here is a link to the list of meeting attendees.

The purpose of the meeting was "to review the industry's strategy for addressing weaknesses in the operational infrastructure of the over-the-counter (OTC) derivatives market" as both regulators and participants urgently seek to address the critical systemic issue of "too entwined to fail."

As discussed by Geithner in his Economics Club speech, key components of the group's plan include:

  • The establishment of a central clearing house for credit default swaps
  • A program to reduce the level of outstanding contracts through bilateral and multilateral netting
  • The incorporation of a protocol for managing defaults into existing and future credit derivatives contracts
  • Concrete targets for achieving substantially greater automation of trading and settlement

But like the introduction of electronic trading to the NYSE, I would suggest, that if successful, what this group is most likely to achieve is the end of their closely knit, opaque and clubby derivatives world, as a central clearing house brings with it the democratization of trading across, not only credit derivatives, but also interest rate, currency and commodity derivatives.

As I wrote in Under the Fed Umbrella last week, seven U.S. banks (JPMorgan (JPM), Citigroup (C), Bank of America (BAC), Wachovia (WB), HSBC (HBC), Wells Fargo (WFC) and Bank of New York (BK)) represent 98% of all U.S. bank derivatives activity, and I would venture that the 17 dealers attending yesterday's meeting at the NY Fed represent an equal or even higher percentage globally.

So, in exchange for their survival, the price to be paid by these firms is a more level playing field. But for an industry whose future profitability is already being questioned, I would suggest that there may be far more at risk in the untangling of the current derivatives world than currently meets the eye.

Between its oligopolistic pricing models and capital efficiency, derivatives trading may have been the ultimate opium of this past decade's credit excesses. As future profits are both dispersed – and reduced - by new entrants to the game, there will be profound changes ahead affecting the top firms in the business.

While I haven't yet thought through all of the implications, I wanted to put these issues out there.

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Positions in SKF, JPM debt obligations
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