Many of the hedge fund industry's chief prime brokers, including Bank of America, Deutsche Bank, Goldman Sachs and J.P. Morgan Chase, are warning their biggest hedge fund clients that trading costs for credit default swaps will go up significantly if the government requires the trades to go through central clearing houses, according to sources familiar with the matter.
Ironically, most hedges funds may not mind.
Credit default swaps are a kind of derivative that allow trades on specific risks, like a bond or debt default. They are popular investments for hedge funds. Historically CDS instruments have been traded in over-the-counter markets, where banks act as intermediaries for the hedge funds to settle on their contracts in exchange for a percentage basis point spread.
But the past year has seen trillions of dollars in credit-default swap trades cleared and settled by two new clearing houses, the Intercontinental Exchange and The Chicago Mercantile Exchange.
And that trend may continue. Part of President Obama's greater financial-reform package is a provision that would require all swap trades to go through central clearing on an exchange. That bill is presently stuck in the Senate.
In addition, the Securities and Exchange Commission is pushing for Congress to allow securities-based swaps to be regulated as strongly as the security that underlies the swap. And such regulation would require a centralized exchange.
"A centralized exchange makes sense for the more standardized derivatives, " says Jeremy Smith, Chief Strategy Officer for SecondMarket, the largest centralized marketplace and auction platform for illiquid assets whose participants collectively manage over $1 trillion in assets available for investment. "However, when it comes to the customized products it's going to take a bit more calculus to figure out the right way to handle them. Maybe there's a solution and maybe there isn't. Legislation is not a bad thing. Bad legislation is a bad thing."