Thursday, March 24, 2011

Derivatives Dealers Grumpy Over Deutsche Bank Ruling

Derivatives dealers worldwide are grumpy because of a ruling by the highest civil court in Germany finding that Deutsche Bank AG was responsible for disclosing the risks of a derivatives transaction to a company that bought an interest rate swap. The German court was concerned by the bank's conflict of interest from the risks in the transaction being stacked in its favor, at the customer's expense. The court especially didn't like the bank's failure to disclose that the customer's starting value in the transaction was an unrealized loss of -80,000 Euros, or over -$100,000. The court noted that although Deutsche Bank had warned the client that the risk of loss was theoretically infinite, it also predicted that the transaction would be profitable for the customer. The court thought the bank should have made loud and clear that the customer's losses could really be costly, and not just theoretically so. (See Wall Street Journal, Dec. 23, 2011, P. C3).

From a derivatives dealer's standpoint, disclosure obligations like those required by the German court seriously erode the dealer's informational advantage. In the financial markets, an informational advantage is more valuable than gold. That's why, as illustrated by the U.S. government's investigation into trading by hedge fund manager Galleon Group and others, there is so much apparent insider trading. Having the informational advantage really pays. If derivatives dealers now have to make disclosures as contemplated by the German ruling, bank profits might suffer. And nothing, as we all know, could be more horrifying than that.

The U.S. SEC's 2010 case against Goldman Sachs for its role in a mortgage-related derivatives transaction called Abacus 2007-AC1 crimped the style of banks acting as underwriters. The German court's ruling may have a bigger day-to-day impact, since it concerns a bank acting as a dealer in the interest rate swaps market. Trillions of dollars of transactions per month take place in this market. Banks are dealers--i.e., they act as principal on one side or the other of the swap--because customers don't want the credit risk of any counterparty other than a very large (and de facto government guaranteed bank). Too-large-to-fail banks of commercially powerful nations like Germany and the U.S. have an advantage in this market, since their governments' implicit guarantees are worth much more than, say, the Greek or Dubai government's guarantee. If the laws of commercially powerful nations like Germany and the U.S. begin to tilt the derivatives playing field toward anything approaching level, the banks may seek more accommodating nations in which to ply their derivatives trade. But, as financial markets globalize, there will be fewer and fewer places for big banks to go. And increasingly savvy corporate clients may abjure from doing transactions routed through a Caribbean island or Equatorial African nation.

Progress on the regulatory reforms in the Dodd-Frank financial legislation enacted last year has, on the best of days, been confined to the slow lane. Big banks have lobbied combatively to limit and water down the changes. The SEC has long known of the informational disparity in the derivatives market, having brought an enforcement case in 1994 that illustrated the problem. See Perhaps the German court's decision will help to encourage U.S. regulators to push through the headwinds of the big bank lobbying juggernaut. Some of the big banks' corporate customers have been convinced to lobby against change. But the German case, and the SEC's 2010 and 1994 cases, reveal that corporate customers sometimes don't even know what they don't know. It's one thing to let people knowingly take risks. It's another thing to leave them unknowing and saddled with risk.

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