Less customization and higher collateral and margin expenses are likely, but central counterparty clearing would mitigate default risks.
Institutional investors could feel a sizable impact from regulatory changes to over-the-counter (OTC) derivatives trading. In the United States and European Union, final rules are still being written, but expectations are that these types of trades could become more expensive, but potentially more appealing to institutional investors.
OTC derivatives, or swaps, are private bilaterally-negotiated transactions in which each party is exposed to the risk that the other could default. Speculative trading in these contracts led to losses for some banks in the aftermath of the 2008 financial crisis, and regulators internationally have sought to gain oversight over the industry.
Under new rules mandated in the United States by the Dodd-Frank Wall Street Reform and Consumer Protection Act and proposed by the European Commission, most of these transactions would be moved to exchanges, where central counterparty clearing mitigates the default risk by making all market participants party to every trade.
In the United States, this provision was slated to take effect on July 16, but rule-writing as mandated by Dodd-Frank has fallen behind deadlines and the Commodity Futures Trading Commission (CFTC), which is writing the rules for the OTC market, has recently pushed back enforcement of the rules until December 31. The lack of clarity has not prohibited OTC derivatives trading, but it has made investors more cautious about entering the market as the rules could change, increasing their risk exposure, says Judson Baker, senior vice president of OTC Derivatives Services at Northern Trust, Chicago.
One result of increased OTC derivatives regulation will be higher collateral and margin requirements, which means that much less capital can be put to work elsewhere.
“If you have a liability driven investment strategy and are heading into OTCs to execute that strategy, the higher amount of collateral you have to put up will have a drag on your returns, plain and simple,” says Peter Cherecwich, global chief operating officer for the asset servicing business at Northern Trust, Chicago.
Even bona fide hedgers, who have some exemptions from the clearing requirement and will not need to post collateral, won’t escape the higher reserve and margin requirements.
“The CFTC is saying the exchanges are accepting performance bonds, so in essence your returns should be the same, but every firm that runs through this analysis cites something completely different,” Baker says. He adds that some of these analyses suggested as much as 120 to 140 basis points of slippage.
Another potential fallout of the new regulations for institutional investors is their ability to precisely customize the contracts to better manage risk is not likely to continue. Instead, there likely will be more “mass customization” to make it easier for exchanges to list and clear the trades. For example, exchanges may create a diverse number of templates that eventually become standardized, Cherecwich says. “That could improve efficiency and thus increase liquidity,” he adds.
The criteria will be whether the exchange can value a swap so it can be accepted for clearing. Currently, a broker-dealer can come up with a product that might include exposure to several different types of markets all in one trade. In the future, the firm may have to instead place several different trades in an attempt to mimic that risk, which it may not be able to replicate exactly. “Rather than customize so much that you’re sitting right on top of your risk, you may end up ‘ballparking’ your risk,” Baker says.
One of the major benefits of the new OTC derivatives rules, however, is increased transparency. Exchange trading allows investors to see the pricing and movements of a security. That means all market participants have access to the same information, leveling the playing field. That could increase participation and thus liquidity, resulting in tighter bid/offer spreads and less jarring price moves.
OTC derivatives trading is global, and regulators from several regions are seeking to harmonize rules and prevent the creation of loopholes that would allow firms to avoid regulation. These rules are still being developed, but Baker thinks ultimately the European Union and the United States, where the majority of trading occurs, will be forced to successfully harmonize derivatives trading rules.
“One thing regulators need to be mindful of is setting up so many barriers that business flees from the United States,” Baker says.
European regulators are having their own struggles in implementing new rules on OTC derivatives. U.S. and EU regulators agree more oversight is needed, but they are still apart on several important issues. Some proposed EU regulations are stricter than those proposed in the United States, such as limits on short-selling and certain credit default swaps. In the United States, only “abusive” swaps are banned from trading, although the definition isn’t clear.
Other EU regulations are looser than those proposed in the United States. The European Union has no restrictions on proprietary trading for banks whereas, via the Volker Rule, the United States would not allow proprietary trading by some banks. Also, the European Union would allow waivers for block trading, but in the United States there is a strict definition of a block trade and reporting requirements when those trades occur.
Cherecwich says that while there will be some differences in the regulatory regimes, he expects them to converge over time. “Part of our job is to make sure we talk to the regulators, which we have done in terms of Dodd-Frank, so that those differences won’t become competitive disadvantages,” he says.
The benefit of moving bilateral OTC derivatives, or swaps, to exchanges is central counterparty clearing. Although having all OTC derivatives subject to central counterparty clearing will cause higher costs initially, eventually that should change.
“Every cost will be borne by the end user, but you’re building up efficiencies over time. You’re driving down the costs from doing an OTC versus during a cleared swap,” Baker says. He notes firms that remain in the bilateral market will be required to pledge more cash or securities for collateral, which is a greater drag on returns.
Some have argued that moving OTC trading to a clearinghouse might inadvertently create a new “too big to fail” entity, but neither Baker nor Cherecwich agree, saying that these entities are too well capitalized for that to happen.
Although the majority of OTC derivatives will be exchange-traded, others will trade on “swap execution facilities,” or SEFs. The definitions for these facilities are still being written, but Dodd-Frank lays a base, suggesting the facility, system or platform should be open to multiple users and allow them to execute or trade swaps by accepting bids and offers from other participants.
Industry firms have asked the CFTC to not define an SEF too much like a traditional exchange, which publicly lists bids and offers. The rationale, these firms say, is that swaps are not traded as often as futures contracts and that some anonymity is needed to encourage their use.
Baker says a possible model exists in the inter-dealer community. “They already have electronic two-way trading platforms for the dealer community, which is an efficient process. Trades are completed and many are then moved to the London Clearing House, which works for about 50% of interest-rate dealings,” he says.
For an SEF to be successful, capital efficiency and liquidity will be critical. Buy-side firms will likely influence how the facilities work. “I think they will fine tune it to meet the buy-side demand,” Baker says.