Over the next few weeks, GlobalCustodian.com will be publishing reports on how the US administrations A New Foundation Report will affect the financial industry. The first topic will focus on over-the-counter (OTC) derivatives.
The Reports Executive Summary makes no bones about its plans for the OTC derivatives market: Comprehensive regulation of all over-the-counter derivatives.
Deeper into the report, the authors argue that past US regulators made a significant error by allowing the OTC derivatives market to go largely unregulated.
In response, the Report demands greater transparency and standardization: To contain systemic risks, the Commodities Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs). To make these measures effective, regulators will need to require that CCPs impose robust margin requirements as well as other necessary risk controls and that customized OTC derivatives are not used solely as a means to avoid using a CCP.
The report also aims for increased market efficiency and price transparency by: moving the standardized part of these markets onto regulated exchanges and regulated transparent electronic trade execution systems for OTC derivatives and by requiring development of a system for timely reporting of trades and prompt dissemination of prices and other trade information.
Standardization is obviously necessary if a financial product is to be traded on an exchange. Common stock, both government and corporate bonds and exchange-traded futures and options are standardized, in the sense that they enjoy the same terms and conditions, and the same entitlements, and are fully fungible, or are geared to well-recognised external benchmarks But how would you standardize OTC derivatives? Standardization implies common start, payment and termination dates, and common legal terms and conditions. Yet OTC derivatives tend to be bespoke, and tailored to the particular needs of the counterparties.
The Report does not state that it wants all derivatives to be on an exchange, instead demanding transparency through increased record keeping and reporting requirements on all OTC derivatives. In other words, the regulators are calling for prices to be reported and published as they are already by bodies such as ISDA and the WMBA. As Tony Freeman, Executive Director, Omgeo, explains, transparency means different things to different people. Transparency can mean the publication of orders and prices in a very public way accessible to everybody, or information used by a regulator to understand the market. It is convenient for a regulator to go to a CCP or an exchange and ask what went on yesterday. That is regulatory transparency, and does not mean that OTC contracts that are currently traded privately bilaterally between two parties needs to be published to the wider market.
Tony Freeman, Executive Director, Omgeo, explains that transparency means different things to different people. Transparency can mean the publication of orders and prices in a very public way accessible to everybody, or information used by a regulator to understand the market.
It is convenient for a regulator to go to a CCP or an exchange and ask what went on yesterday. Thats regulatory transparency, and doesnt mean that OTC contracts that are currently traded privately bilaterally between two parties needs to be published to the wider market.
Many would argue that regulatory transparency has already achieved. The Wholesale Market Brokers Association sees no problem with increased transparency. Alex McDonald, CEO, said, WMBA welcomes the move to increase transparency in the OTC markets through the wider use of central counterparty clearing in order to monitor the net exposure of all market participants. This objective is achievable within the operations of the OTC marketplace as electronic post-trade transparency is already widely available.
Many of the inter-dealer brokers already look like exchanges, particularly when their electronic trading platforms are structurally similar to an exchange. In this instance, regulatory transparency is a case of reporting information, rather than a radical re-haul of business strategy.
It is also important to note that a relaitively high proportion of OTC derivaitves – notably interest rate swaps – are already cleared via CCPs such as SwapClear. In this respect, regulators are one step behind the market.
Similarly, the desire expressed in the Report for OTC derivatives to be moved onto exchanges is also partially achieved already. As Freeman explains: The move of standardized OTC derivatives onto exchanges has already started. Where people were trading OTC but it was physically possible to trade on an exchange, the buy-side customers are making that transition.
In other words, the shift is client driven. Freeman continues: There may previously have been good reasons for a client to do an OTC trade but for some their instinct seems to be moving towards exchange-traded if that option is available. This is being driven by primarily by pricing and liquidity concerns but is also being affected by reputation-issues. Some buy-side firms are concerned about being seen as heavily involved in a market that has received such negative publicity. Public sector plan sponsors for example would be concerned about this issue.
The industry consensus is that many of the demands of the Report are either being achieved already or can be easily achieved. The unspoken fear is this: will the regulators stop their demands at standardization and transparency?
Eventually, with increased transparency and reporting, and clearing of all standardized OTC derivatives through regulated central counterparties, regulators may start to wonder if they can force OTC derivatives trading on to exchanges.
Many in the industry would riposte that the more esoteric nature of some custom-made OTC derivatives makes this impossible, and that the practical effect would therefore be to eradicate a useful investment tool simply because it is bi-lateral in nature. It will also be a significant challenge to standardize many OTC derivatives – a fact which regulators do not appear yet to fully comprehend. Even a simple interest rate swap will have varying start, finish and payment dates, depending on the bespoke demands of each counterparty. To put such an instrument on exchange will require significant modifications to trading technology – even if it did not inadvertently kill off the market.
As with any change in the industry infrastructure, various players have spotted threats and opportunities in the proposed changes. In a testimony before the House Financial Services Subcommittee, the Depository Trust & Clearing Corporation (DTCC) called for maintaining a single trade repository for OTC derivatives contracts. This is a role that the DTCC has assumed in recent times through the construction of its OTC Trade Information Warehouse.
Larry E. Thompson, DTCC General Counsel, said, We are concerned that some in the OTC derivatives market may assume, once a trade guarantee is provided through a central counterparty, there may be less need for a central registry to track the underlying position data.
This concern is justified. With regulatory overhaul comes increased competition. The Repot states that: Competition between appropriately regulated OTC derivatives markets and regulated exchanges would make both sets of markets more efficient and thereby better serve end-users of derivatives. There is no reason to suspect that regulators do not want competition to stretch from the front to the back office. Competition may be irrelevant if more OTC derivatives become standardized, and data becomes more transparent. In this scenario, DTCCs Trade Information Warehouse may become redundant.
It is also noticeable that the industry is not in arms about the prospect of tighter regulation. Instead, there is a resigned feeling that increased regulation is an inevitability, no matter what its form. There is also an expectation of increased costs. While this will be the case for reporting costs, transaction costs may buck the trend and decrease. Brokers will be betting that CCPs, by cutting transaction and capital costs, will boost the trading volumes on which they feed. The historical trend is that after a market gains a more efficient infrastructure, transaction costs decrease in line with higher trading volumes. The battle for market share between incumbent exchanges and new MTFs post-MiFID is a good example of such a trend. Unfortunately, as both MTFs and exchanges are finding out, associated profits decrease dramatically alongside transaction costs, at least during the transition phase to a new and more stable order that follows consolidation.
Luckily, while markets may not be strictly efficient, they are certainly Darwinian in nature, and as we have already seen within the OTC derivatives market, the move to adapt to inevitable regulation has already begun.
Giles Turner, News Editor, Global Custodian
See also GC.tv interview Chris Edmonds, of the NASDAQ subsidiary International Derivatives Clearing Group mandatory derivatives clearing