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The Lynch Amendment Stirs Up Battle in Derivatives Reform

A battle is brewing over the so-called Lynch Amendment that would block large bank dealers from owning more than 20 percent of an OTC derivatives clearinghouse.

A battle is brewing over the so-called Lynch Amendment that would block large bank dealers from controlling the OTC derivatives clearinghouse.The Futures Industry Association has sent a letter to Congress opposing an amendment to the House of Representatives legislation on financial reform legislation, on the grounds that it reduces competition.The amendment is being proposed by Rep. Stephen Lynch (D-Mass) and is designed to prevent financial firms from controlling OTC derivatives clearinghouses, according to the FIA's letter and other published reports.

Under the Lynch amendment no financial services entity can own more than 20 percent of the clearinghouse. "The Amendment's stated purpose is to prevent one group of market participants - the bank dealers- from blocking other market participants from accessing clearing. But appropriate CFTC and SEC regulation for clearing would prevent any denial of fair and open access to clearing services for all participants."

The FIA contends,"Clearing members may legitimately want to own a stake in the clearing house and have a say in how their capital will be used. That is sensible and fair representation, not a conflict of interest," according to the letter.

"In addition to reducing competition, the amendment would prevent clearing members that put up their capital to guarantee trades through clearing from having a meaningful voice in the operations of any clearinghouse," stated the FIA's media advisory.

The FIA argues that the existing bills which place regulation of OTC derivatives under the SEC and CFTC already address these issues, without "hampering competition among clearing platforms in any way. In fact, the bills require clearing houses to adopt governance arrangement that support the objectives of their participants. The Lynch Amendment should be defeated," concluded the FIA.

In an interview prior to the FIA letter coming out, Paul Zubulake, senior analyst at Aite Group, questioned the terms of the amendment. "Why 20 percent? Obviously, the players in the industry are going to be involved in the process of processing and clearing the trades. Who else is going to come in and be a counterparty; who is going to be a member of the OTC clearinghouses?" asked Zubulake.

But the reason that Rep. Lynch is proposing the Lynch amendment is to make sure that the bank dealers that heavily dominate the OTC derivatives business can't continue to do this when the new rules are put in place.

Here's the other side of the story, as argued by the blog Rortybomb.

The clearinghouse is a private entity and the owners get to set the margins and set all the rules. Right now the OTC derivative market is heavily dominated by a few financial firms, with 5 firms (1. JPMorgan Chase, 2. Goldman Sachs, 3. Bank of America, 4. Citibank, 5. HSBC.) accounting for 97% of the notional amount of all derivative contracts. And four out of five of those banks are TARP recipients, so they have gotten some cheap capital that they could be looking to invest. So pretend you are the CEO of a large financial firm, who wants to manipulate this situation. What's the obvious move? Think of it yet?

Why not just buy the exchange?

So here's a simple amendment, by Stephen Lynch (D. Mass). Here's the crucial part of it:

(B) BENEFICIAL OWNERSHIP BY A RESTRICTED OWNER - The rules of a clearing agency that clears security-based swaps shall provide that a restricted owner shall not be permitted directly or indirectly to acquire beneficial ownership of interest in the agency or in persons with a controlling interest in the agency, to the extent that such an acquisition would result in restricted owners controlling more than 20 percent of the votes entitled to be cast on any matter by the holders of the ownership interests.

Financial firms can't own more than 20% of the exchanges. That's it. No Exchange Czars. No additional government regulator to fall asleep at the wheel. No complicated Rube Goldberg device with a "let's nudge someone to do something with taxpayer money" payoff structure. Competition. People looking out for their own money. Level playing field. Simple, good ideas. Let's have a large number of market participants, looking out for their own interests, owning these things, instead of a subsidiary of the largest banks. Because in that case, we don't need to invoke a metaphor for regulatory capture, say 'cognitive capture' or 'social capital'; it wouldn't be a metaphor - they'd actually own the mechanism we expect to regulate them."

Instead, Rortybomb wants the amendment to curb the dealers' influence on the clearinghouses to let smaller innovators compete by moving the instruments to exchanges. It argues that dealers make money on credit default swaps by trading them over-the-counter which keeps the spreads wider and by using their credit rating to post less collateral and by letting competitors enter, those spreads will narrow."

This amendment should move you if you believe (a) the largest banks have a concentration of political power and need to be curbed and (b) the government should be in the business of defending markets, not big businesses.

Rortybomb expects the Securities Industry Financial Markets Association (SIFMA) and International Swaps and Derivatives Association (ISDA) to fight and try and break this amendment by saying that it's the anti-competitive. But defenders of the Lynch amendment could hold their ground as well. This is shaping up to be a feisty battle.A battle is brewing over the so-called Lynch Amendment that would block large bank dealers from owning more than 20 percent of an OTC derivatives clearinghouse. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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