NEW YORK (Reuters) - When Barney Frank, former U.S. Democratic Congressman and co-author of the Dodd-Frank 2010 banking legislation, set about reforming the U.S. $300 trillion derivatives markets, he felt the key was to foster competition.
What he discovered, though, was that some in the financial services industry, ostensibly big proponents of free markets, did not necessarily feel the same way.
Frank held a meeting with two representatives from insurance firms at his office in Newton, Massachusetts, to discuss proposals to trade derivatives on exchanges, a shift that would bring price transparency, lower trading costs, and draw in new entrants.
The younger of the two representatives told Frank that public prices would allow people to undercut him. When the famously combative Frank challenged the man, the second, elder insurance attendee quickly jumped in to state that they would not be advancing that argument.
“That was the clincher,” that showed the motivation of many firms pushing back against the new rules, Frank said in a recent interview with Reuters. “People don’t like competition but people find it very hard to argue against it... They love to see other people engage in it, and cheer for it, but they aren’t so crazy about participating.”
Five years after the failure of investment bank Lehman Brothers, rules to require central clearing and electronic trading of derivative contracts that Frank, a 30-year Congressman who retired in January, pushed for are finally being implemented.
Frank, along with former Democrat Senator Christopher Dodd were the chief architects of the 2010 Wall Street law aimed at reforming financial services following the 2007-2009 financial crisis which was blamed in part on large bank positions in derivatives.
The process of implementing rules has been hard fought. Banks have slowed and watered down reforms while also pushing for wide exemptions will allow a number of market participants to skirt clearing and trading mandates.
Arguments that derivatives are ill-suited to exchange trading fall flat with Frank. Migration to this new type of trading was expected to happen quickly after the 2008 financial crisis, but encountered strong bank resistance.
“Of course it is (suited to exchanges)... where else do they think we shouldn’t have competition? The hypocrisy here is just stunning,” said Frank, adding that many businesses see competition as a “spectator sport.”
The markets will see more transparency, Frank said, and with that will come more entrants. “Maybe I have more confidence in the free market and competition than some of these guys,” he said.
Frank is similarly dismissive of arguments he heard that price transparency is impractical to implement, would harm liquidity, and hurt smaller companies that rely on derivatives to hedge their businesses, often referred to as end-users.
“I did not hear from that many end-users,” Frank said, though one large user of commodities derivatives told him that he did not need a lot of what the banks were arguing for. “I think they were probably implicitly coerced by their bankers.”
Frank sees many of the arguments against price transparency as a disguise for the banks’ own interests. Central clearing removes the credit risk of trades that ties investors to the largest banks, and opens markets to electronic trading that allow any participants to trade with another.
“The people in the derivatives business always say ‘Oh, but this isn’t for us, this is for the end-users, these are for the people that need hedges for their business, et cetera.’”
“We said, ‘Fine, let’s use competition to bring down the cost,’” Frank said. “I think the case for competition is obvious.”
The continued dominance of a few large banks in derivatives’ markets since Lehman’s failure has been a point of contention among many market participants.
Concentration, especially in the credit derivatives market, has increased since Lehman’s failure due to the crisis-era acquisitions of other banks, and as smaller dealers pare back their activity.
Competition in credit derivatives has also been the focus of antitrust investigations in Europe and the U.S. and is currently the subject of numerous lawsuits that state that banks have impeded electronic trading in an attempt to restrict new entrants and preserve market share.
Frank said he is not concerned with a bank’s market share if they are winning business due to their efficiency.
“The question is not the size alone but what’s happened to the price, what’s the reason for the size,” he said. “By competition, what we say is you have to publish the price, you’re not forcing anyone to go with a competitor but you’re giving them the opportunity.”
Reporting By Karen Brettell; editing by Clive McKeef