Banks to Congress: “Don’t Fence Us In” – $20 Billion Derivative Revenue at Stake, but Not Future of the Business

Wednesday, April 28, 2010

Congress’ derivative legislation work is stumbling about as the “big banks” press to avoid constraints on their money machine. $20 billion annual revenues is certainly worth fighting for, but it raises an important question: What are they doing with derivatives that is worth $20 billion?

A key answer is “spread.” “Custom-designed” and privately-traded derivatives do not have the advantage of narrow, visible spreads that standard-designed and publicly-traded securities do. Add to that Wall Street’s marketing machinery, selling “risk management” through derivatives, and you have an excellent setup to take a sizeable cut of every deal.

Remember that banks live on spread. It can be in basic banking (the simple difference between cost of funds and loan rates) or in the complex derivative business. For decades, basic banking has been the subject of reporting and regulation for the good of the financial system. But that basic banking oversight didn’t occur overnight. The system had to go through many problem periods to provide the experience and understanding necessary for wise controls.

Turning to derivatives, here is a good summary of where things stand today (From “Banks Falter in Rules Fight – Democrats Push Restrictions on Derivatives Trading; Showdown Looms in Senate,The Wall Street Journal, by Damian Paletta and Scott Patterson, April 14):

“Trading in derivatives is concentrated in five large Wall Street banks—J.P. Morgan, Goldman, Morgan Stanley, Bank of America Corp. and Citigroup Inc. The business produced revenues of about $20 billion last year, according to Comptroller of the Currency and industry estimates.

“Unlike stocks and bonds, which are traded in public, most derivative deals are private agreements between two parties. Goldman, J.P. Morgan and Morgan Stanley have at least one common objective: To thwart or dilute proposals that would push trading in most derivatives onto exchanges or to “clearinghouses,” which are middleman institutions set up to handle big transactions between banks.

“Their main concern: Trading on exchanges or via clearinghouses could reveal more details about the pricing and structure of the deals, potentially benefiting rivals and clients, and in the process eating into profits. Banks have also argued that any requirements that their customers use standardized derivative products, instead of individually customized deals, would limit customers’ flexibility.”

The fact that derivatives are lucrative isn’t reason enough that today’s setup should remain unaltered. The problems that derivatives have just caused (and the enormous sums involved) have provided the experience and understanding to design sound controls. If Congress succeeds in creating legislation that removes some of derivatives’ major risks to the financial system, do not expect the business to dry up. Derivatives’ risk control and financial stability characteristics are desirable, so the business will continue. What it will lose is some of its free-ranging wildness that adds risk and financial instability elsewhere.

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April 2010