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Derivatives Trading: Stays Behind the Veil?

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Big banks are on top again. About a fortnight ago, the industry won a major victory after the Commodity Futures Trading Commission agreed to soften standards for derivatives trading for banks.

The rules as envisioned earlier required that asset managers contact a minimum of five banks when determining a price for a derivatives contract. But now the commission has agreed to lower the number of banks required to two.

This number will increase to three by 2014, but many market watchers believe that even this number would be too low. Then there is the skepticism about rules expected in the future never coming into effect.

The market for derivatives is worth nearly $700 trillion. A group of five banks account for nearly all, in fact in excess of 90%, of derivatives contracts: JPMorgan Chase & Co. (JPM - Free Report) , The Goldman Sachs Group, Inc. (GS - Free Report) , Bank of America Corporation (BAC - Free Report) , Citigroup, Inc. (C - Free Report) and Morgan Stanley (MS - Free Report) .

The original regulations were part of the reforms required by the Dodd-Frank legislation. The intent was to increase transparency and competition in the derivatives market. It is widely believed that the dominance of a few large players was one of the major reasons of the 2008 crisis. The Dodd-Frank legislation outlines a system where derivatives will be traded on “swap execution facilities” which will be similar to equity and futures exchanges.

Additionally, the original set of rules required trading to be conducted on open electronic platforms. But the final rules allow much of the discussion over prices of derivatives to be conducted over the phone. This will make it even tougher to monitor these negotiations.

Many market watchers believe that the new set of regulations has returned the system to conditions which existed just before the crisis. But this may not be entirely true.

The deal is an outcome of fierce negotiations within the commission which consists of five members. The chairman of the commission, Gary Gensler, was in favor of a more stringent set of rules. But in the absence of a third vote, he had to give in to opposing members and Mark Wetjen, who, though a fellow Democrat, is batting on behalf of the big banks.

Wetjen was of the view that the need to consult five banks was arbitrary. While supporting the two-bank requirement, he said this would not prevent asset managers from asking for additional quotes. In fact, other regulatory bodies have posed far easier standards for derivatives markets.

Gensler, for his part, has argued that despite the relaxation in regulations, derivatives will have to be traded on regulated platforms of the like where stocks are traded. Additionally, other regulations will come into force which will make substantial portions of derivatives subject to regulatory scrutiny.

The only issue here is that Gensler is scheduled to depart from the commission later this year. And the White House has provided no indications that it will provide him with another term.

Some officials are of the view that the next incumbent may also be able to complete the pro-reform Gensler’s agenda. Also, Gensler has announced June 30 as the deadline for finishing the process he has started.

But Wetjen believes that his efforts were directed at providing the markets with increased flexibility. This would also mean there would be greater freedom to market participants.

However, Wetjen has his critics, who are not in favor of easier regulations, saying they work against the transparency and increased competition which the Dodd-Frank legislation had envisaged. The jury is out on whether Gensler will be able to complete his agenda. In that case, the reforms put forth by Dodd-Frank will remain far from complete.

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