Yesterday,Treasury Secretary Timothy Geithner signaled that regulators would mandate more transparency into OTC derivatives products and force trading of credit default swaps onto exchanges.

In a joint press conference, Geithner, Securities Exchange Commission Chairman Mary Schapiro and Commodity Futures Trading Commission (CFTC) acting Chairman Michael Dunn, talked about developing a new regulatory framework for OTC derivatives, which played a role in the financial crisis.

But it is unclear from the media coverage whether Geithner is going to mandate electronic trading of credit default swaps or allow them to be traded bilaterally via the dealers and push for the central clearing model instead.

According to Dow Jones’coverage, the plan would force all standardized OTC contracts to be traded on regulated exchanges and cleared through a central clearing model. The more customized products would be subject to record-keeping and reporting requirements, according to Dow Jones.

But is this a good time for the regulator to force the dealers to trade the credit derivatives and other OTC derivatives on exchanges when they are just getting used to central clearing?

“I’m against mandates. The market is already moving toward the clearing model for over-the-counter products,” commented Paul Zubulake, senior analyst at Aite Group. “You had this market movement to a central clearinghouse model, but again to mandate trading on an electronic platform for price transparency, that’s something that might develop over time,” said Zubulake.

Several clearinghouses only went live in the last few months, including the ICE Trust spearheaded by the IntercontinentalExchange, which has the support of the bulge-bracket dealers, while NYSE Euronext through Liffe’s BClear platform is operating since last October in Europe. Meanwhile, CME Group/Citadel Investments's joint venture, CMDX received Federal Reserve and SEC regulatory approvals in March, but is not yet live because it’s said to be waiting for more buy-side participation to use the CDS central counterparty clearing platform(CCP).

Any moves toward transparency will benefit the buy-side and disadvantage the sell-side, warned Zubulake. “(There will be) more transparency for the buy side and less spread for the sell-side,” says the analyst. “I think it comes down to a buy-side customer,” he said. If the buy-side can save money by clearing everything (listed futures) and credit default swaps through the CME, then they’re going to trade via CME, so CME is in the game,” says Zubulake.

But if the Treasury were to require dealers to trade CDS on exchanges, “Bottom line, margins are going to get squeezed,” says Zubulake. “If they move all of the over-the-counter products to exchanges, I don’t think that ‘s good for the dealers’ bottom line. But that’s the administration’s motto— they’re going to make change,” said Zubulake.
Meanwhile, the industry is expected to get more details on Giethner’s plans to overhaul financial regulation in the next two to three weeks. Of course central to that plan is which regulator will oversee OTC derivatives. Given that the CFTC oversees listed futures and has done a solid job with that, while the SEC has been much maligned in its handling of credit derivative exposures and leverage during the crisis, there could be a showdown between the two agencies. On the other hand, the SEC has ten times the budget of the CFTC, and so it has more power, suggested Zubulake.

There’s also the potential for a merger between the CFTC and the SEC, not to mention the Congressional infighting. “Congress has infighting because the (House Financial Services and Senate Agricultural) committees that handle the regulatory bodies are fighting for power,” he warned. The upshot of all this is that OTC derivatives will undergo a regulatory overhaul. “I’m expecting a big bombshell over the next two to three weeks,” said Zubulake.