Q&A: Why are swaps in focus for financial reform bill?

(BestGrowthStock) – As the long debate about toughening U.S. financial regulations comes to a head, Democrats are set to maintain an aggressive last-minute measure that would effectively ban banks from trading swaps, the strictest yet to emerge from a global effort to crack down on bank risk.

Initially seen as a bargaining chip that could be sacrificed in order to gain Republic support for broader reform, Agriculture Committee Chairwoman Blanche Lincoln’s proposal to require banks to spin off their entire swaps trading operations or forfeit key supports, such as access to the Federal Reserve window, remained in the bill after a round of closed-door negotiations at the weekend, sources said.

Senate Majority Leader Harry Reid has set a procedural vote to begin debate on the bill for late on Monday. Republicans have vowed to vote to block consideration of it, although closed-door talks about a bipartisan agreement carried on.

Lincoln’s proposal also included tough requirements for clearing and exchange-based trading of swaps, although efforts to bring more transparency to the largely over-the-counter swaps market had already been widely anticipated.

The measure renewed discussion about the role of the little-understood $400 trillion swaps market in global finance, which extend far beyond the credit-default swaps (CDS) that were partly blamed for exacerbating the financial crisis.

WHAT IS A SWAP?

A swap is a kind of derivative that allows one party to exchange an asset or liability for a similar asset or liability for the purpose of lengthening or shortening maturities, or otherwise shifting risks. Usually traded over-the-counter, swaps can allow companies to lower the cost of hedging their exposure to unpredictable interest rates or commodity prices, and also to craft more customized products tailored to their specific risks; but they also give speculators the chance to bet on the same thing, all while avoiding hefty margin costs.

There are many different kinds of swaps that often differ in purpose and structure, and while the main purpose of the bill is to increase regulation of credit-related derivatives — which account for a relatively small portion of the overall swaps business — it doesn’t exclude other types.

ARE SWAPS AND DERIVATIVES THE SAME THING?

No. A derivative, broadly speaking, is a financial instrument that ‘derives’ its value from something else. A swap is a type of derivative, but so are futures and options.

A futures contract is a derivative traded on an exchange that gives the buyer the right to pay today’s price for a specific asset to be delivered at some point in the future. In futures, a clearinghouse is the middleman between buyers and sellers. With a swap, deals have typically been concluded privately and bilaterally, the actual asset rarely changes hands, and the two parties settle the trade with one or a series of cash payments depending on price movements. The cash flow that actually changes hands is far smaller than the $400 trillion notional, unnetted size of the overall swaps market often cited. The Bank for International Settlements said the total exchanged between counterparties to swaps transactions is more like $20-$40 billion per year.

WHAT KIND OF SWAPS ARE THERE?

By far the biggest pool of swaps are on interest rates, allowing one party to “swap” a liability or asset that is attached to a floating interest rate against a fixed one. These have existed for a number of years and are generally used by companies that want to hedge against future rates. According to the most recent data from the BIS effective June 2009, some 86 percent of all outstanding OTC swaps were on interest rates, just over $340 trillion, with another 4 percent on foreign exchange and less than 1 percent on equities and commodities.

WHY ARE SWAPS THE FOCUS OF REFORM?

Swap contracts came into focus with the dramatic growth of the credit default swaps (CDS) market, which allowed counterparties to protect against (or profit from) a credit default or restructuring by a company or country. These were partly blamed for precipitating the financial crisis as more speculators began using them as a way to bet against creditworthiness, while insurers like AIG that sold the swaps struggled to keep up with payments as credit conditions worsened and they were unable to offload the positions due to their limited liquidity. CDS contracts made up about 9 percent of all OTC swaps last June, or some $24 trillion, BIS data showed.

WHAT IS THE BENEFIT OF A SWAP?

There are two primary benefits: Because they had been generally agreed between two parties and not necessarily standardized, swaps could be tailor-made to whatever terms were required, allowing a hedger to reduce basis risk.

Also, because the contracts were generally not cleared through an exchange, they did not require the counterparties to set aside large amounts of cash for margin calls, provided the two sides of the trade had existing credit agreements.

ARE ALL SWAP CONTRACTS TRADED OVER-THE-COUNTER?

No, but in the past most were. With the onset of the financial crisis, a growing share of OTC swaps are traded through clearinghouses, which significantly reduce the risk that a counterparty will default on the deal. Part of the U.S. regulatory reform efforts would force most or all standardized swaps to trade through exchanges and clearing houses in order to bring greater transparency to the market.

WHO TRADES SWAPS AND WHY?

Banks are the biggest traders of swaps contracts, with JPMorgan Chase and Goldman Sachs the largest among their peers. Just five banks account for 97 percent of the over $200 trillion worth of derivatives held by U.S. commercial banks. In recent years hedge funds have also entered the market as a way to speculate on rates.

But many of the world’s biggest companies hold the other sides of those contracts, buying or trading swaps to control their rate, forex or commodity price risks. Many experts argue that without banks to provide liquidity to this vast market, the cost of buying those swaps would rise significantly.

HOW WOULD SPINNING OFF SWAPS DESKS WORK?

Nobody knows. Bankers and traders say it would be extremely difficult to separate swaps desks from other parts of a bank’s risk management and trading operations, particularly given that swaps may be traded by entirely different departments.

WHY DOES THE SENATE AGRICULTURE COMMITTEE HAVE A SAY?

The Agriculture Committee has oversight of the Commodity Futures Trading Commission (CFTC), which is the government’s regulator of futures exchanges. Because of the push to trade swaps contracts on those same exchanges, the CFTC would become responsible for regulating this large market.

SO WHAT HAPPENS NEXT?

The Senate will vote later on Monday whether or not to begin debate over a unified financial reform bill, which at the moment appears to include the swaps ban. The full Senate will vote on the package, which could happen within weeks, although it will need the support of at least one Republican.

However, after that the Senate bill must still go into conference with the House of Representatives, which passed its own version of financial reform last year. Lawmakers selected to the conference committee hammer out final details before the bill goes to a final vote in the House and Senate. Only then will it go to President Obama to sign into law.

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(Writing by Jonathan Leff; Editing by Andrea Ricci)

Q&A: Why are swaps in focus for financial reform bill?