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Spotlight-blackOTC Derivatives Reform (more stories)

22 October 2012

Swaps Dealers Face Conflicts of Interest … or Not

As swap dealers prepare for life under Dodd-Frank, they must address the potential for conflicts of interest among their research groups, trading desks and clearing units.

Amidst all the ISDA protocols and risk policies that swap dealers are preparing for the ever-shifting Dodd-Frank registration deadline, there is a little-known section of the internal business conduct (IBC) rule that must be addressed. It is §23.605 – Conflict of Interest Policies and Procedures, and it aims to address two possible situations in swaps, one that appears simple but is actually complicated and one that appears more complicated but is actually simpler.

1. Research Conflicts

The one that appears simple, but is actually complicated, involves research reports on derivatives. What the rule attempts to address is the possibility that trading positions might influence the content of research reports, a problem that past New York attorney general Eliot Spitzer highlighted several years ago.

On the surface, this appears to be a manageable requirement; but writing a rule about it, and implementing one, is anything but simple. To see why, let’s look at two very different situations:

In the first, a firm’s research group comes to the conclusion that a certain kind of swap is attractive. Before the report goes public, the traders in that product area need to prepare the firm to respond to anticipated customer demand, so they take positions in line with the research recommendations.

In the second scenario, the trading desk finds itself in positions that have losses and it needs to get out. To assist in that effort, the traders enlist the research department to publish favorable reports, which may not be supported by objective analysis. So here we have two diametrically opposed situations with identical outcomes – the trading and research orientations are aligned.

The CFTC attempted to address this dichotomy by prescribing the behind-the-scenes relationships, including supervision, compensation, and internal and external communication, among others. Some of the commission’s language is unclear at best, and unworkable at worst, so it behooves a swaps dealer to take a practical view of the relationship between trading and research. Essentially, that entails one-way communication, in which research output could influence trading positions, but trading positions cannot influence research output.

2. Clearing Conflicts

The conflict that appears complicated, but may be somewhat simpler, is between the clearing unit and the trading unit. This reflects the concern on the part of Congress and regulators that large banks could tie trading to clearing, or vice versa. The great fear was that the big clearing institutions would refuse to clear for customers unless those customers traded with them. As the market has evolved, these concerns may have fallen away somewhat, but the language is in the rule, so the swaps dealer has to conform.

What makes conformance particularly difficult is a trend across all derivatives markets (futures, options and swaps) to combine execution and clearing, both as client offerings and as business units. While this makes sense for both vendors and customers, it complicates the conflict of interest question immeasurably.

In particular, the rule says that trading units cannot influence the clearing unit’s decisions about: whom to clear for, what DCO to use, what risk parameters to use, and what fees to charge. Interestingly, there is no language about the clearing unit’s influencing the trading unit’s relationship with a customer.

Reading through the rule, one could easily conclude that, in the current market, it is unenforceable. The CFTC recognized that and attempted to provide some clarity in a footnote, not to the rule, but to the preamble. The footnote allows “discounted clearing services in connection with trading activities, provided that the business trading unit personnel comply with applicable prohibitions and restrictions on their interactions with the clearing unit.”

So what do we do with this requirement? Perhaps the best answer is to establish a “list price” for clearing services, and discount from that price for a variety of market reasons. But we never charge more than list, and we never tell a client that we won’t clear for them if they don’t trade with us, or vice versa.

Will these steps keep us out of trouble? It appears that only the CFTC will know for sure. Do you want to ask them, or should I?

Spotlight-white-trans For more stories in the OTC Derivatives Reform Spotlight Series click here.

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