Morgan Stanley's Sly Exchange Investment


The Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress' attempt to fix the country's financial system in the wake of the financial crash, was passed in July 2010. It's almost 2013, yet some of the most important parts of the law have yet to come into full effect. This hasn't stopped many banks from trying to get ahead of the curve and anticipate where things are going to fall out, however.

At least that's what the smart ones are doing, such as Wall Street perennial Morgan Stanley .

As clear as a stock exchange
Probably the best known part of Dodd-Frank is the Volcker Rule. Named after ex-Federal Reserve Chairman Paul Volcker, the Volker Rule attempts to rein in Wall Street excess by restricting the types of trades banks can make with their own money. A lesser known but equally important Dodd-Frank reform revolves around derivatives trading.

Since their invention, derivatives have been traded over-the-counter, or OTC, with each bank running its own trading desk, cutting and vetting its own deals, with no central exchange that lets market participants -- and regulators -- get a bigger picture of who's placed bets with whom. This is the exact opposite of the world of equity trading, where massive exchanges such as the New York Stock Exchange and the Nasdaq give both investors and regulators very transparent pictures of what's going on in the those markets.

This lack of transparency was one of the underlying causes of the financial crash, particularly in the world of credit default swaps -- a type of derivative -- as companies that had heavily traded in CDSes found themselves unable to cover their bets as the banking system as a whole began to collapse. The worst offender of this bunch wasn't even a bank; it was American International Group . AIG, which Fed Chairman Ben Bernanke once described as an insurer with a hedge fund attached, almost singlehandedly brought down the U.S. financial system because of its massive exposure to CDSes, which it couldn't cover as failing banks began to call in their chits.

Keeping their eyes ahead of the ball
So Dodd-Frank seeks to get derivatives trading out of the OTC world and onto regulated trading platforms. Details of this particular Dodd-Frank reform are still being worked out, but Morgan Stanley is wisely trying to get ahead of the curve with the information at hand. To wit, Financial Times is reporting that the bank is planning "to make a strategic equity investment" in Eris Exchange, a company that specializes in "swap futures." According to the FT, Morgan will be acquiring a minority share in Eris, which is based in Chicago.

"As the traditional OTC rates swap market undergoes significant structural, economic, and regulatory changes," says Morgan's head of liquid flow rates, Patrick Haskell, "Morgan Stanley believes that Eris Exchange and its futurized swaps are ideally suited to provide our clients with flexible alternatives."

Morgan seems pleased with the deal, and so should investors. The times they are a-changing. Between the Volcker rule and new derivatives rules, banks will no longer be able to make the easy money they once did off these previously high-margin lines of business. Morgan has already made a move in the new, post Dodd-Frank direction: Its deal to buy out the remainder of Morgan Stanley Smith Barney from Citigroup signals that Morgan is taking very seriously the burgeoning business of wealth management.

Of all the banks that made it through the financial crash intact, Morgan has probably struggled the most to regain its footing and find a place for itself in the new financial order. This sly investment in Eris Exchange, coupled with its move into wealth management, demonstrates a management team with its eye not just on where the ball is now, but also where it's headed.

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