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Dodd-Frank, Derivatives Clearing And Risk Shifting

|Includes: The Bank of New York Mellon Corporation (BK)

With the advent of new rules and regulations, particularly one as sweeping as the Dodd Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). there are bound to be those who alter their strategic plans as a result. At 848 pages long, this legislation has resulted in hundreds of new mandates, none of which are thought to be trivial in nature.

Evidence of the regulatory fallout comes in the form of a recent decision by BNY Mellon to close its swaps clearing offering, "just three years after the firm launched its business in an attempt to profit from the Dodd Frank mandate for clearing over-the-counter swaps." Reasons given, according to reporter Mike Kentz, include anemic activity that "has fallen short of expectations." He cites a BNY Mellon spokesperson at saying that "We are exiting the derivatives clearing business in the US due to market and regulatory factors that will limit our ability to grow the business in the future." In "Derivatives: BNY to shut down clearing service" (International Financing Review, December 5, 2013), the point is made that new entrants bid down prices to garner market share but are finding that the allure of a loss leader role is fast fading. This means that others may join BNY Mellon in exiting a marketplace that is deemed to be unprofitable. As a result, buyside users of over-the-counter (OTC) swaps will eventually see prices rise. Added capital requirements, along with the expense of having to augment technology and processing staff are a few of the real costs associated with clearing OTC swaps in a post-Dodd Frank world. Interested readers can download BYN Mellon's 2013 derivatives clearing guide.

Large banks are not alone in dealing with what many continue to describe as onerous mandates. In "Dodd-Frank Red Tape Strangling Small Banks To Death" (Investor's Business Daily, December 4, 2013), reporter Paul Sperry informs readers that, based on Federal Deposit Insurance Corporation ("FDIC") data, the number of federally insured institutions has fallen to a new low. He adds that community banks have "suffered the greatest number of casualties" due to the cost of compliance with Dodd-Frank.

Besides explicit costs, there are opportunity costs and the price tag associated with the law of unintended consequences." This means that a regulation, once passed into law, almost always costs people much more than any initial feasibility study suggests. Fiscal Times reporter Rob Garver agrees. In "How Dodd-Frank Shifted the Risk Instead of Burying It" (December 13, 2013), he offers that a concern about "too big to fail" banks could soon be replaced with worries about "too big to fail" clearing houses. His reference to a recent paper by Professor Adam Levitin is noteworthy. In "Response: The Tenuous Case for Derivatives Clearinghouses" (Georgetown Law Journal, 2013), this legal scholar describes access to capital as a "significant advantage over dealer banks" but warns that ineffective risk management could be the economic death knell for many market participants. He writes that "If clearinghouses underprice risk, they can fuel moral hazard that encourages greater and riskier use of swaps. Clearinghouses may or may not price for risk correctly...Whether clearinghouses are better risk managers than dealer banks is not a testable, falsifiable proposition..." and "heavily depends on the details of clearing-house and dealer-bank risk management."

In 2011, Fed Chairman Ben Bernanke talked at length about the need for effective risk management on the part of clearinghouses. In his April 4, 2011 speech at the 2011 Financial Markets Conference, this head of the Board of Governors of the Federal Reserve System praised clearinghouses in different countries as having "generally performed well in the highly stressed financial environment of the recent crisis" but urged executives to consider ways to improve on the current structure, especially since "the need for strong risk management and oversight will only increase as we go forward." Click to read "Clearinghouses, Financial Stability, and Financial Reform."

Speaking of risk management, I was appalled to hear a participant in a conference call recently tell me that my questions about a service provider's risk mitigation policies and procedures were misplaced. This gentleman opined that the numbers speak for themselves and one should not need to delve further. This topic is left for another blog post, a lengthy one at that. Suffice it to say, the risk management infrastructure in place (or not) is a critical part of determining the magnitude of uncertainty of dealing with any one particular organization. For now, interested readers may want to read my article entitled "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Dr. Susan Mangiero (AFP Exchange, 2003). Note that BVA, LLC is now known as Fiduciary Leadership, LLC.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.