Derivatives

Increased transparency in the derivatives markets resulting from Dodd-Frank should also be beneficial in terms of systemic risk reduction by placing specific controls around OTC derivatives. As has been previously noted, OTC derivatives contracts and most structured products are currently traded in a largely unregulated environment.

We believe the law will increase transparency and reduce credit exposure without significantly affecting the transfer of risk in the market. The new mandates will require large derivative trading firms to execute transactions electronically in an exchange or swap execution facility, clear through a clearinghouse, and report to a trade repository. Trades that are exempt from these requirements will face a higher capital charge, reflecting their additional risk. The resulting reduction in counterparty credit risk among trading partners is a significant element of the law's goal to reduce the inter-connectivity among major securities dealers.

The law also requires insured banks to spin off or “push out” non-hedging related derivative trading to separate affiliates. As this area becomes clarified by regulators, the ultimate impact on the market can be better discerned. As it stands, we expect that the impact will be largely organizational, with associated capital implications. We do not expect this provision to significantly affect trading.

The combination of electronic markets, clearing, and reporting will add significantly to market depth and liquidity. This will level the playing field for less creditworthy counterparties and foster greater price competition among a larger group of market makers. Less liquid products, such as some of the more esoteric credit default swaps (CDSs) and collateralized debt obligations (CDOs), stand the most to gain in terms of price discovery and spread compression.

Fixed Income

Almost nothing in the law, outside of the ban on bank-related proprietary trading, will directly affect overall operation of the U.S. fixed income market. Specific areas will be impacted, such as asset backed securitization where underwriters are required to retain 5% of the credit risk in originated securities. A similar risk retention requirement will exist for certain types of non-exempt residential mortgage backed securities as well; however, the securities that will be affected have yet to be determined. We believe that this will be positive for the markets as underwriters will now have some “skin in the game,” increasing their due diligence.

New accountability facing credit rating firms (including legal liability to investors for their ratings) should bolster their accuracy and independence and restore some confidence in their assessment of creditworthiness. This should be a welcomed change since credit rating arbitrage, coupled with insufficient investor due diligence, played a significant role leading up to the structured credit market meltdown.

Perhaps the most interesting part of the law with respect to the fixed income market will be the effect that electronic trading of fixed income derivatives has on the underlying cash markets. We believe movement toward more robust electronic trading is inevitable for most fixed income securities as the efficiencies derived from current technology are too overwhelming to be ignored. More advanced electronic trading is currently conducted almost exclusively among the major market participants. Forthcoming changes to the derivatives market may well provide the catalyst for more widespread adoption of electronic trading.