A planned U.S. government skake-up of the derivatives sector could allow smaller banks to challenge Wall Street's dominance of the market, according to the top executive of interdealer broker GFI Group Inc. (GFIG).

The Treasury-backed push toward central clearing and electronic execution of over-the-counter, or OTC, contracts would curb the advantage held by large institutions in the multi-trillion-dollar market.

Michael Gooch, chief executive of GFI, said the large balance sheets of the dominant banks currently make them a safer counterparty in bilateral OTC deals.

That has given big banks a lock on the business. Gooch noted a report from the Office of the Comptroller of the Currency that showed the top four derivatives dealers in the U.S. holding 94% of the market at the end of 2008.

"Central clearing will make [OTC trading] more expensive and reduce margins, but balance sheets will no longer be as important," said Gooch, whose company facilitates inter-bank trading across multiple asset classes.

"It has the potential of increasing the participation and profit margins of some of the smaller broker-dealer players," he said.

He pointed to Jefferies Group Inc. (JEF), a specialist in mid-sized companies and a large corporate fixed-income broker, which doesn't do much credit default swap business.

Gooch said this was because the bank doesn't have the balance sheet to provide competitive CDS pricing to customers, though the instruments trade in a somewhat similar fashion to some fixed income products.

Central CDS clearing, which has been developed by exchanges like IntercontinentalExchange Inc. (ICE) and CME Group Inc. (CME), would let banks like Jefferies offer the swaps and other OTC products to customers, who would be safe from any counterparty risk.

"When you hear about resistance [to clearing] in the dealer community, I think it's more the eight or nine biggest banks who are less inclined to have a central counterparty unless they control it themselves," Gooch said.

For its part, GFI welcomed Wednesday's proposal by U.S. authorities to bolster oversight of over-the-counter derivatives, and Gooch said that central clearing will provide improved transparency, more liquidity and higher volumes in the market.

Inter-dealer brokers like GFI have been hit by a slowdown in off-exchange trading, as participants shy away from counterparty risk associated with bilateral deals.

The possibility that mandatory clearing could fuel increased trade in OTC products sent GFI shares 13.6% higher Thursday to $5.25.

Whereas other interdealer brokers fretted Thursday that shifting over-the-counter instruments toward exchange platforms could mean less business for the IDB sector, Gooch noted that close to 60% of GFI's business is already centrally cleared.

"Look at the equities markets," Gooch said, which make up about a quarter of GFI's revenue.

"They're the most highly regulated, transparent and centrally cleared, yet there's a significant role played by broker-dealers in execution transaction, research and advice. That's still going to happen," he said.

Gooch estimated that within two years 80% of GFI's business would be cleared, with the adoption of the central counterparty model in credit, currency and interest rate derivatives.

-By Jacob Bunge, Dow Jones Newswires; (312) 750 4117; jacob.bunge@dowjones.com