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(Reuters) – The role of banks in the $615-trillion over-the-counter derivatives markets is a central point of contention as U.S. lawmakers work to finalize sweeping financial reforms in the wake of the global financial crisis.

DEALS

Democrat Barney Frank — who will chair the House-Senate panel that next month will iron out differences on the package — said he disagreed with a proposal from Senator Blanche Lincoln to force banks to spin off swaps trading desks.

The remarks from Frank, a Wall Street critic who chairs the House Financial Services Committee, have been interpreted as the death knell for Lincoln’s provision.

Other tough requirements from Lincoln, chairman of the Senate Agriculture Committee, remain, including mandates for clearing and exchange-based trading of swaps to bring more transparency to the market and to reduce counterparty risk.

The debate has spurred discussion about the role of the little-understood swaps market in global finance, which extends far beyond the credit-default swaps that were blamed for exacerbating the financial crisis.

WHAT IS A SWAP?

A swap is a kind of derivative that allows one party to exchange an asset or liability for a similar asset or liability for the purpose of lengthening or shortening maturities, or otherwise shifting risks. Usually traded over the counter, swaps can allow companies to lower the cost of hedging their exposure to unpredictable interest rates or commodity prices, and also to craft more customized products tailored to their specific risks; but they also give speculators the chance to bet on the same thing, all while avoiding hefty margin costs.

There are many different kinds of swaps that often differ in purpose and structure, and while the main purpose of the bill is to increase regulation of credit-related derivatives — which account for a relatively small portion of the overall swaps business — it does not exclude other types.

ARE SWAPS AND DERIVATIVES THE SAME THING?

No. A derivative, broadly speaking, is a financial instrument that ‘derives’ its value from something else. A swap is a type of derivative, but so are futures and options.

A futures contract is a derivative traded on an exchange that gives the buyer the right to pay today’s price for a specific asset to be delivered at some point in the future. In futures, a clearinghouse is the middleman between buyers and sellers. With a swap, deals have typically been concluded privately and bilaterally, the actual asset rarely changes hands, and the two parties settle the trade with one or a series of cash payments depending on price movements.

While the total value of OTC derivatives is $615 trillion according to the Bank for International Settlements, that figure includes options, forwards and other derivatives that are not swaps. When those are removed, the estimated value of the swaps market in December 2009 was $425 trillion.

The cash flow that actually changes hands is far smaller. The BIS said the total exchanged between counterparties to swaps transactions is more like $20 billion-$40 billion per year.

WHAT KIND OF SWAPS ARE THERE?

By far the biggest pool of swaps are on interest rates, allowing one party to “swap” a liability or asset that is attached to a floating interest rate against a fixed one. These have existed for a number of years and are generally used by companies that want to hedge against future rates. According to the most recent data from the BIS effective December 2009, some 82 percent of all defined OTC swaps were on interest rates, just over $349 trillion, with another 5 percent on foreign exchange and less than 1 percent on equities and commodities.

(BIS table: r.reuters.com/jyb98j)

WHY ARE SWAPS THE FOCUS OF REFORM?

Swap contracts came into focus with the dramatic growth of the credit default swaps (CDS) market, which allowed counterparties to protect against (or profit from) a credit default or restructuring by a company or country. These were partly blamed for precipitating the financial crisis as more speculators began using them as a way to bet against creditworthiness, while insurers like AIG that sold the swaps struggled to keep up with payments as credit conditions worsened and they were unable to offload the positions due to their limited liquidity. CDS contracts made up almost 8 percent of all OTC swaps last December, or some $33 trillion, BIS data showed.

WHAT IS THE BENEFIT OF A SWAP?

There are two primary benefits: Because they had been generally agreed between two parties and not necessarily standardized, swaps could be tailor-made to whatever terms were required, allowing a hedger to reduce basis risk.

Also, because the contracts were generally not cleared through an exchange, they did not require the counterparties to set aside large amounts of cash for margin calls, provided the two sides of the trade had existing credit agreements.

ARE ALL SWAP CONTRACTS TRADED OVER THE COUNTER?

No, but in the past most were. With the onset of the financial crisis, a growing share of OTC swaps are traded through clearinghouses, which significantly reduce the risk that a counterparty will default on the deal. Part of the U.S. regulatory reform efforts would force most or all standardized swaps to trade through exchanges and clearing houses in order to bring greater transparency to the market.

WHO TRADES SWAPS AND WHY?

Banks are the biggest traders of swaps contracts, with JPMorgan Chase and Goldman Sachs the largest among their peers. Just five banks account for 97 percent of the over $200 trillion worth of derivatives held by U.S. commercial banks. In recent years hedge funds have also entered the market as a way to speculate on rates.

But many of the world’s biggest companies hold the other sides of those contracts, buying or trading swaps to control their rate, forex or commodity price risks. Many experts argue that without banks to provide liquidity to this vast market, the cost of buying those swaps would rise significantly.

HOW WOULD SPINNING OFF SWAPS DESKS WORK?

Bankers and traders say it would be extremely difficult to separate swaps desks from other parts of a bank’s risk management and trading operations, particularly given that swaps may be traded by entirely different departments.

Lincoln has said that banks could spin off their desks to affiliates and that her provision would not affect banks’ ability to hedge their own risks associated with loans.

SO WHAT HAPPENS NEXT?

Lawmakers named by House and Senate leaders this month will resolve differences between the bill passed by the Senate in May and one passed by the House in December. Frank will chair the committee, which will be controlled by Democrats.

Democrats hope to have a final version signed into law by President Barack Obama by the July 4 congressional recess.

Regulators will then need to work out how to implement the new law. The CFTC has estimated it may need to write more than 20 new rules to establish the finer details of its new powers.

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