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Will Financial Reform Slam the Derivatives Market?

By Matt Koppenheffer - Updated Apr 6, 2017 at 11:33AM

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Will the freshly signed financial reform bill wreak havoc on the derivatives market?

Like Zeus from Mount Olympus, President Obama hurled a devastating thunderbolt at the derivatives industry with his signing of the financial reform bill. Or something like that.

In fact, when it comes to derivatives -- or really everything in the bill -- there's very little that we know for sure. And trying to wade through the 2,000-plus page bill doesn't yield a whole lot of certainty thanks to language like this:

STANDARD FOR CLEARING -- It shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization that is registered under this Act or a derivatives clearing organization that is exempt from registration under this Act if the swap is required to be cleared.

I've read Ikea assembly instructions that were far more clear.

Convoluted verbiage aside, the new derivatives regulations don't do a whole lot yet. The task of molding the general guidelines into enforceable rules and regulations will fall on the Commodity Futures Trading Commission and the SEC.

But while rule-setting processes will happen over the next few years, we obviously want to try to get ahead of that train and figure out what impact the new rules might have.

Derivatives reform winners
What can be better than a government mandate that Wall Street use your services? That has to be running through the heads of the folks at the major exchanges and clearinghouses, as a key part of the derivatives reform bill requires a vast amount of the shadowy "over the counter" derivative market to be cleared and put on exchanges.

But from an investor's point of view, where do you look to benefit from all of this? There are a few easy picks. CME Group (NYSE: CME) and IntercontinentalExchange (NYSE: ICE) both are frontrunners to take a chunk of the new business, as both have already been knocking at the door of the over-the-counter market in the U.S. Nasdaq OMX (Nasdaq: NDAQ) will also be looking to grab a piece through its majority-owned International Derivatives Clearing Group.

It gets a bit more complicated from there as there are a host of other firms such as LCH.Clearnet and Tradeweb. Tradeweb is majority owned by Thomson Reuters, but both companies have a laundry list of backers that includes major Wall Street firms like Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), JPMorgan Chase (NYSE: JPM), and Citigroup (NYSE: C).

Yup, that Goldman Sachs and that Citigroup. Are you really that surprised?

Only time will tell which companies will claim the biggest share of the regulatory windfall, but it seems likely that all those involved will get some nice padding on their bottom lines.

The losers ... but by how much?
A lot of ink has been spilled regarding how new derivatives rules will impact the big Wall Street banks. To be sure, all signs do seem to be pointing toward this being a negative for the industry.

Two provisions in particular are likely to weigh on Wall Street. First, there are the issues that we discussed above -- that many derivatives will have to be cleared and traded on exchanges -- which will crunch the profitability of Wall Street's derivatives business. In addition, there's a provision that prevents banks from taking part in certain swap contracts, and that may knock the Wall Streeters out of certain parts of the derivatives landscape altogether.

In short, it will hurt and maybe even hurt badly. But for how long and by how much?

Jumping to a different part of the reform bill for a moment, banks will now face limits on fees for debit card transactions. So what are they doing? They're looking to recoup lost profits from other parts of the business by doing things like introducing checking account fees. Or, as JPMorgan's Jamie Dimon recently put it, "If you're a restaurant and you can't charge for the soda, you're going to charge more for the burger ... Over time, it will all be repriced into the business."

I expect nothing less when it comes to derivatives; though they may get pinched in one area, they will undoubtedly look to make it up in other areas. Picture the banks like water balloons, squeeze them in one spot, and they will just bulge in another.

More too big to fail?!
A final thought on the derivatives portion of the overhaul bill brings us to the always fun law of unintended consequences.

Much of the discussion of derivatives takes place in the bill's Title VII. However, the section that follows, Title VIII, or "Payment, Clearing, and Settlement Supervision" contains a worrisome development. Last week, I took a look at the Financial Stability Oversight Council. Well, they've popped up again in this section:

The Council, on a non-delegable basis and by a vote of not fewer than 2⁄3 of members then serving, including an affirmative vote by the Chairperson of the Council, shall designate those financial market utilities or payment, clearing, or settlement activities that the Council determines are, or are likely to become, systemically important. [Emphasis mine.]

Those final words "systemically important" should whack you in the face like a Mike Tyson one-two combo. Haven't we heard those words before? Oh yeah, that's right, when we bailed out the major Wall Street banks.

Head a little bit further down in the bill and we get confirmation:

The Board of Governors may authorize a Federal Reserve bank ... to provide to a designated financial market utility discount and borrowing privileges only in unusual or exigent circumstances ...

Is it just me, or does it sound like we've just created a new group of, if not too big to fail, then at least too important to fail, institutions? So much for no more bailouts.

Have some thoughts of your own on derivatives reform? Head down to the comments section and be heard.

Skeptical that the U.S. economy is getting back on track? Check out the big opportunity that Tim Hanson thinks is hatching overseas.

Motley Fool Options has recommended writing covered calls on Nasdaq OMX Group, which is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.

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Stocks Mentioned

JPMorgan Chase & Co. Stock Quote
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Citigroup Inc. Stock Quote
Citigroup Inc.
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Morgan Stanley Stock Quote
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Nasdaq, Inc. Stock Quote
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Intercontinental Exchange, Inc. Stock Quote
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