Not too big to flail?

Perhaps this time the Big Banks won't be able to keep their little cost-plus monopoly game, this story suggests:

Wall Street Stealth Lobby Defends $35 Billion Derivatives Haul

The five biggest derivatives dealers in the U.S. -- JPMorgan, Goldman Sachs, Bank of America, Morgan Stanley and Citigroup Inc. -- held 95 percent of the $291 trillion in notional derivatives value of the country’s 25 largest bank holding companies at the end of the first quarter. More than 90 percent of those derivatives were traded over the counter.

The so-called OTC market consists of privately negotiated contracts that enable companies or investors to hedge against or bet on swings in the value of bonds, interest rates, currencies, commodities or stocks. Unlike exchanges, the business is unregulated and prices aren’t public.

Five U.S. commercial banks, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Bank of America Corp., are on track to earn more than $35 billion this year trading unregulated derivatives contracts.

When a company or investor wants to enter into a swap, the bank checks internal pricing sources to determine the cost of making the opposite trade with another bank, which would enable it to eliminate any exposure on the trade. Armed with that information, it then offers a higher swap price to the client, allowing the bank to pocket a profit.

“Part of the pull and tug is that the banks are trying to prevent more and more of the product from being commoditized in the sense of being exchange-traded,” said Charles Peabody, an analyst at Portales Partners LLC in New York, which provides institutional equity research. “Like anything that starts to get commoditized -- we’ve seen that with Trace on the bond side -- it’s obviously going to pressure margins.”

Trace, shorthand for the Trade Reporting and Compliance Engine, was created in 2002 to post prices on all registered corporate bonds 15 minutes after trades occur. The public disclosure meant bond dealers no longer had better price data than clients, and profit margins in the business shrank by more than 50 percent

The Obama plan would require that the most common, or standardized, OTC derivatives be processed through clearinghouses, whose members would make good on trades in the event any of them default. Wall Street expected that the administration would try to mandate clearinghouses. It didn’t anticipate the proposals would go further by requiring standardized trades be listed on exchanges or regulated platforms that entail reporting of trades, according to people familiar with how the legislation developed and who asked not to be named.

The plan also seeks to limit sales of derivatives to individuals and small municipalities to make sure unsophisticated investors don’t get talked into contracts they don’t understand.

For Wall Street, the longer it takes to get legislation passed the better. As stock market values and the economy improve, anger at banks is likely to subside.

In a bad omen for the industry, the Obama administration kept the details and timing of its plan to regulate the derivatives markets under wraps before making it public earlier this month.

Robert Pickel, head of the International Swaps and Derivatives Association, and Scott DeFife, chief lobbyist for the Securities Industry and Financial Markets Association, were meeting with Deputy Treasury Secretary Neal Wolin on Aug. 11, when Wolin mentioned that the proposals would be sent to Congress in 60 minutes, according to a person familiar with the meeting. The sudden notice was not what they were used to.

“The administration is desirous of maintaining control and the initiative on this,” said Craig Pirrong, a finance professor at the University of Houston who has testified before Congress about derivatives trading. “They wanted to make sure they could get their vision out there pure and uninfluenced by the industry.”

Fascinating story, in its details. Read it.