Deutsche Bank Gets Six-Month Ban on Derivatives Trading in Korea

(Bloomberg) -- Deutsche Bank AG was banned from proprietary stock and derivatives trading for six months in South Korea after regulators said the lender triggered a stock market rout that erased $26 billion of market value.

The Financial Services Commission will ask prosecutors to investigate five Deutsche Bank employees, Choi Kyu Yun, standing commissioner of the regulator, told reporters in Seoul yesterday. Deutsche Bank said it was “disappointed” by the recommendations, and will cooperate with Korean authorities, according to a statement.

The slump in the benchmark Kospi index during the last minutes of trading on Nov. 11 prompted regulators to limit the number of equity derivative contracts investors can hold. The penalty against the local unit comes amid heightened scrutiny globally of equity-market swings since a 20-minute drop in U.S. equities on May 6 briefly erased $862 billion of market value.

“Penalties are quite natural if trades were made intentionally to distort markets,” said Im Jeong Jae, a fund manager in Seoul at Shinhan BNP Paribas Asset Management Co., which oversees $29 billion of assets. “As trading gets more complex, it’s almost impossible to have perfect rules and systems in place to regulate it.”

The regulator said it didn’t file a complaint with South Korean prosecutors against Deutsche Securities Korea Co.’s parent company. Still, the FSC has notified South Korean prosecutors and the Federal Financial Supervisory Authority of Germany about potential misconduct by the parent company, it said. Deutsche Bank said it will hold an independent review of systems and controls at its Asian Equities Absolute Strategies Group. The regulator didn’t identify the five employees.

Sell Orders

Regulators began investigating Deutsche Bank units in Seoul and Hong Kong after the Financial Supervisory Service said about 1.6 trillion won ($1.4 billion) of sell orders were made through the company’s Korean brokerage unit.

Korea Exchange Inc. said the Kospi’s tumble on Nov. 11, when options expired, was caused by “program” selling. Deutsche Bank breached stock exchange rules governing the disclosure of computer-driven trades by filing a report one minute late that day, the bourse said on Nov. 15.

Korea Exchange will hold a meeting Feb. 25 to discuss penalties for the local brokerage unit, Lee Cheol Jae, an executive director at the bourse operator’s market oversight division, said by telephone.

Deutsche Bank units allegedly made 45 billion won of “unfair” trading profit on Nov. 11, the FSC said today.

Limits on Contracts

Under the tightened rules on South Korean derivatives holdings announced by the Financial Services Commission on Jan. 11, institutional investors will be allowed a maximum 10,000 futures and options contracts in any “speculative” transaction.

While institutions are now limited to 7,500 futures contracts and individuals can hold 5,000 futures contracts, there are no limits on options. The nation’s bourse operator said on Jan. 31 that the new rule would start from March 7.

Japanese regulators have said they will ban investors from short-selling stocks with the intention of buying back the shares in public offerings to rein in price volatility.

Bank suggests a minimum threshold for derivatives rules

First Tennessee Bank National Association is urging the Commodity Futures Trading Commission to consider a minimum threshold for companies that will be subjected to rules being drafted on the use of derivatives. The bank suggested that the rules apply only to companies that engage in more than 500 swaps annually.

The bank also pointed to a legal precedent for its idea: that in the Gramm-Leach-Bliley Act of 1999, "a bank that effects...not more than 500 transactions in securities in any calendar year is exempted from the definition of 'broker.'"

The threshold idea was addressed from a different vantage point by the Committee on Futures and Derivatives Regulation of the New York City Bar Association. The Bar Association recommended, instead, that regulators specify a minimum dollar amount of net exposure, below which an end-user would not be considered to have "substantial counterparty exposure." It suggested factoring in offsetting trades, central clearing to reduce counterparty risk and the amount and quality of collateral posted.

The thinking goes that counting the number of contracts is a less meaningful way to gauge risk.

In the futures world, counting contracts is more useful in assessing leverage and risk, said Holland West, a senior partner at law firm Dechert, but it doesn't work for tailor-made over-the-counter derivatives.

"Futures are standardized, so just by multiplication you can get to a rough position value, whereas with swaps your exposure bears no relation to your number of contracts or your contract value," he said.

A better test, he said, would be a specified net exposure over a reasonable period of time that would show how much the firm was in or out of the money on its trades. "It has to be a sort of average or look-back because you can't just foot-fault one day and be counted, or conversely reduce your balance sheet risk around earnings periods and not be counted," Mr. West said.

http://online.wsj.com/article/SB10001424052748704116004575522782759846268.html

Eris Exchange about to launch

(Crain's) — A new Chicago exchange created by five local trading firms will begin to trade interest rate-swap futures Monday, with clearing provided by CME Group Inc.

Eris Exchange is being launched by DRW Holdings LLC, Getco LLC, Infinium Capital Management LLC, Chicago Trading Co. and Nico Holdings LLC, which all have also invested in the new entity. The firms tapped Neal Brady, a former CME executive, as CEO. Eris arrives on the scene just after President Barack Obama signed a sweeping financial regulation bill that, among other things, will force more derivatives to be traded on exchanges and cleared in the public domain as opposed to private, over-the-counter transactions. Mr. Brady told reporters on a conference call that Eris will provide the transparency, additional competition and central clearing that regulators have been advocating.

“The timing couldn’t be better, given the financial reform bill that got signed into law last night,” Mr. Brady said.

In the past, trading firms and Chicago-based CME, the biggest derivative exchange operator in the world, sometimes expressed different views of regulators’ efforts to push over-the-counter derivative trading to exchanges and central clearing. While the firms favored it, the CME at times said it feared such a mandate might push some business overseas. CME will provide the clearing services through its CME Clearing unit.

“By offering clearing services for the interest rate futures contracts executed on Eris, their customers are able to benefit from CME Clearing’s proven risk-management track record,” the exchange said today in a statement.

The founding firms will be “committed market makers” for the platform, the firms said in a press release. The exchange, which has already started working with about eight likely clients, will operate as a “request for quote” electronic trading platform with market makers receiving every request, according to the release.

The over-the-counter derivatives market is large, with more than $600 trillion in notional amounts outstanding at the end of last year and $21.6 trillion in gross market value, according to the Bank for International Settlements.

Interest rate swaps make up the biggest portion of the market, Mr. Brady noted. He declined to predict what percentage of the market the new exchange might attract.

Don Wilson, DRW’s CEO, said he expects the new contracts to appeal to the market largely because they will be more easily customized for a particular firm’s needs than current alternatives. The Eris futures contracts, each of which has a face value of $1 million, can be tailored with any coupon rate or any maturity, according to the release.

“People have the ability to match the cash flows that they need to hedge with a fairly customized product,” Mr. Wilson said on the conference call.

Prior to taking the post, Mr. Brady was a managing partner at Chicago-based Third Stone Partners LLC, which is also an investor in Eris. At CME, which he left last year, Mr. Brady had been the global head of business development. He joined CME in 2004 after it bought a company he founded called Liquidity Direct Technology LLC.

While Mr. Brady acknowledged on the call that it’s “tough to know” how the new idea will play out, he expects significant volume to migrate to the exchange.

“Our assumption is that, shortly, a wide group of (firms) will be online,” Mr. Brady says.

Derivatives proposal would have far-reaching effects

Sen. Blanche Lincoln, D-Ark., got a measure into the regulatory-reform bill that would force banks to divest their derivatives-trading operations.

While the measure could still die, it shows that lawmakers are willing to consider ideas that could seriously affect derivatives portfolios of major banks, according to The Wall Street Journal.

The proposal likely would have a number of consequences for banks, bank-stock investors and taxpayers.

http://online.wsj.com/article/SB10001424052748703465204575208553099924076.html

Here is the OCC data for the end of 2009 report (March 19, 2010)

Commercial bank, total derivatives and leverage --

> > JP Morgan, $78 trillion and 48/1 leverage

> > Bank of America, $44 trillion and 30/1 leverage

> > Goldman Sachs, $41 trillion and 457/1 leverage

> > Citigroup, $37 trillion and 32/1 leverage

> > Wells Fargo, $4 trillion and 4/1 leverage

More at Risk: http://freerisk.org/wiki/index.php/Derivatives_concentration

Buffett continues lobbying despite derivatives agreement

Warren Buffett's Berkshire Hathaway is continuing to lobby key senators on derivatives regulation that could help Buffett avoid a big financial hit. It is unclear what impact a deal on derivatives regulation reached between two key Democrats would have on Buffett's request. Buffett wants existing derivatives contracts exempt from proposed rules.

http://online.wsj.com/article/SB10001424052748703441404575206252252365076.html

Sens. Dodd, Lincoln strike deal on strict derivatives rules

Senate banking committee Chairman Christopher Dodd, D-Conn., and Senate Agriculture Committee Chairwoman Blanche Lincoln, D-Ark., reached an agreement that could force banks to spin off their derivatives-trading operations. The Obama administration has voiced concern that proposed rules would consolidate derivatives trading among only a handful of powerful firms. Under the proposal, banks that keep their derivatives-trading desk would be ineligible for federal aid from the Federal Reserve and the Federal Deposit Insurance Corp.

http://www.nytimes.com/2010/04/26/business/26regulate.html?ref=business

Mutual funds' use of derivatives concerns regulators

The Securities and Exchange Commission recently said it is looking into the use of derivatives by mutual funds, exchange-traded funds and other investment firms, concerned that the financial instruments and the risks they pose are not fully understood by market participants. Many investors might be surprised to learn the extent to which derivatives, including options, swaps and futures, are used by mutual funds.

The review is likely to focus on the over-the-counter market, especially for interest-rate and credit-default swaps, which are used by firms including BlackRock Inc., Allianz SE's Pimco, and Western Asset Management Co., a unit of Legg Mason Inc., said Michael Herbst, an analyst at Morningstar Inc. Over-the-counter derivatives are traded privately rather than through commodity exchanges, which are regulated by the Commodity Futures Trading Commission.

Those three managers are some of the biggest users of derivatives, Mr. Herbst said. "A wide range might use them a bit more sparingly." Among the reasons for using them, he said, would be gain or magnify exposure to markets or interest rates, and to hedge against risk in a portfolio.

Some investors may be surprised to learn that many core bond mutual funds use derivatives extensively. Among them are Pimco Total Return Fund (trading symbol PTTAX) and BlackRock Total Return Fund I (MDHQX) and II (BCBAX), Mr. Herbst said. In addition, Western Asset Management Core (WACSX) and Western Asset Core Plus (WAPSX) funds have used them in the past, but probably do so a little less today, he said.

Western Asset Management confirmed that its Core and Core Plus funds are using derivatives less. The asset manager discloses all of its holdings in its annual reports, a spokeswoman said.

BlackRock declined to comment on its funds' use of derivatives, and Pimco didn't respond to a request for comment.

Absolute-return and commodity funds also make use of derivatives.

Eric Jacobson, director of fixed-income research at Morningstar, said use of mortgage derivatives by funds has made a comeback since the 2008 crisis. Interest-only and inverse interest-only mortgage securities, which can be lucrative but volatile, are reappearing. Putnam Income (PINCX), Putnam U.S. Government Income (PGSIX) and Putnam American Government Income (PAGVX) funds had "bold allocations" to IO and inverse-IO securities as of the end of March, he said.

http://online.wsj.com/article/SB10001424052702304830104575171850624361326.html

SEC reviews investment companies' use of derivatives

Mary Schapiro, chairman of the Securities and Exchange Commission, said the agency is reviewing the use of derivatives. "It's appropriate to engage in a more thorough review of the use of derivatives by [exchange-traded funds] and mutual funds given the questions surrounding the risks associated with the derivative instruments underlying many funds," Schapiro said.

more at http://www.nytimes.com/2010/03/26/business/26sec.html?ref=business

Signs emerge that Europe, U.S. are diverging on derivatives reform

Policymakers in Europe and the U.S. will kick off the year by tackling the overhaul of financial regulation, including rules related to the derivatives market. However, indications are coming to light that the U.S. and Europe are diverging in their approach to overhauling derivatives regulation. "Should there be a disparity between levels of capital charges, market participants will simply move to the business center with lower capital charges," said David Clark, chairman of the Wholesale Market Brokers Association.

Derivatives aren't sole cause of crisis

Robert Reoch, a credit derivatives consultant, uses a crash by a modified sports car as an analogy for the financial crisis and derivatives. Reoch explains that derivatives themselves are not to blame for the crisis. "As with so many things in life, accidents are mainly caused by the driver, not the vehicle," he writes.

http://news.bbc.co.uk/2/hi/business/8428315.stm

Revenue potential in OTC derivatives clearing, bank says

Morgan Stanley estimated that $1 billion in revenue is up for grabs as over-the-counter derivatives contracts start trading through central clearinghouses. "We expect significant levels of standardized OTC derivatives to be centrally cleared in two to three years, driven by changes in legislation and regulation, decreased tolerance for counterparty risk post-Lehman, increased demand for transparency, and reduction of systematic risk," Morgan Stanley said.

more at http://uk.reuters.com/article/idUKTRE5BG2RD20091217

Debate on derivatives, clearinghouses continues

Derivatives have been the focus of regulatory debate lately, but they remain a useful tool, said Nobel economist Myron Scholes. Banning them would be a "Luddite response that takes financial markets back decades," Scholes said. Regulators think trading derivatives through clearinghouses would make them safer, but doing so would hurt banks' profit and make certain corporate hedging prohibitively expensive.

more at http://www.economist.com/opinion/displaystory.cfm?story_id=14843667

Regulating derivatives could do more harm than good

Rep. Eric Cantor, R-Va., writes that lawmakers are focusing on an easy target -- the derivatives market -- rather than identifying and tackling the root causes of the global financial crisis. Cantor, the Republican whip, warns that new regulations being considered by Congress could do irreparable damage to businesses and consumers. "Rather than the tool for gross financial manipulation it is portrayed to be, the derivatives market plays a very important role in solidifying the competitiveness of American businesses," Cantor writes.

more at http://www.investors.com/NewsAndAnalysis/Article.aspx?id=509198

Geithner presses Congress for rules on derivatives market

Treasury Secretary Timothy Geithner is seeking laws for the $592 trillion derivatives market. Geithner is set to testify before a joint hearing of the House Agriculture and Financial Services committees to call for requiring all "standardized" contracts to be traded on exchanges or other regulated platforms. Disclosure rules also would apply to the derivatives contracts, Geithner said.

more at

http://www.bloomberg.com/apps/news?pid=20601087&sid=aPEwq7aBXjn0