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Regulating OTC Derivatives: Will It Solve Systemic Risk?

Over the last 30 years, as the over-the-counter (OTC) derivatives market grew dramatically and became truly international, derivatives were largely overlooked in the financial regulatory framework – until now. The aftermath of the credit crisis ushered in a new wave of regulatory reform that seeks to eliminate systemic risk from the financial markets. In the U.S., the Dodd-Frank Act covers investment adviser registration, consumer protection, living wills, mortgages, and – for the first time – regulation of the OTC derivatives market, often viewed as the main culprit behind the economic collapse.

Recent testimony in Washington has highlighted how Title VII of Dodd-Frank will require the U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) to create rules relating to security-based swaps and swaps that address mandatory clearing; the operation of execution facilities and data repositories; capital and margin requirements and business conduct standards for dealers and major participants; and regulatory access to and public transparency for transaction information.

The aim is to move away from a bilateral OTC market and towards an electronically traded, centrally cleared model with targeted benefits expected to improve pricing and proper valuation of trades, allow transparency and reporting to the regulators to monitor the market, reduce counterparty risk and, hence, systemic risk, and, finally, to ensure that there is enough capital held against these trade positions for adverse market conditions, thereby, eliminating the need for future government-funded bailouts.

Regulators across Europe and Asia are enacting similar reforms and, on these key themes, it seems that all the regulators globally agree. However, regulatory bodies have not provided adequate details and guidelines on the new rules or instructions for implementation. Due to lack of clarity, the need for additional collateral and the costs involved in achieving compliance have put pressure on the profitability of derivatives and structured products.

Gaming the Regulations

As with all financial markets, some environments are more conducive to doing business than others, especially when it comes to access to commodities, local laws, time zones, culture and language. Historically, financial centers have thrived in New York, London, Frankfurt, Paris, Hong Kong and Tokyo.

Another driver to business strategy has often been tax structure. Various tax regimes have either encouraged businesses to grow or challenged them to relocate to more tax efficient locations. Certainly, governments have been loath to lose money centers, hubs of finance and captains of industry to policy decisions. Regulation has been much the same – nations do not want to be put at a competitive disadvantage by implementing overly burdensome regulations. Too much regulation will impact profitability, with firms relocating all or parts of their businesses to more profitable locations, while too little regulation could produce the onset of another credit crisis.

Currently, there are small discrepancies in regulatory requirements between Europe, the U.S., Canada and Asia, and this is proving to be a fine balancing act for legislators. It is one thing to implement a domestic policy that eliminates systemic risk, but if a company can operate in another geography that has failed to eliminate those practices, then the systemic risk persists.

Increased Costs with Questionable Results

The primary objective of current OTC regulatory reform is to avoid another global financial crisis. However, questions remain about the effectiveness of the central clearinghouses (CCPs) and the fundamental shift in managing OTC derivatives.

Addressing a “Too-Big-to-Fail” Situation

With reforms aimed at removing systemic risks in OTC derivatives (as in the case of Lehman Brothers’ counterparty risk) by introducing CCPs, there is a growing argument that moving all derivative trades to one or more clearing houses would shift the risk to the clearinghouse. There is still a concern that a clearinghouse, given the same economic conditions from the last crisis, would be in danger of default and pose a risk to the financial markets as a whole. Thus, it would be considered “too big to fail,” despite its intent to prevent any “too-big-to-fail” situations.

Non-Standardized Derivative Products

Another argument against the effectiveness of CCPs is that they only exist for products that have a market standard for trading and processing. This may be the case for a large part of the derivatives world – e.g., Single Name Credit Default Swaps (CDS) or Interest Rate Swaps (IRS) – but, historically, a large portion of the market is tailored to each client’s specific needs.

Implications for Cross-Asset Margining

Finally, the CCP model can only be efficient if all trades are accepted and there is only one CCP. This would reflect netting margin and collateral based on Value-at-Risk (VaR). Companies often have large numbers of derivatives trades with the same counterparties and these trades have different exposures and values, which are then netted off to give a net exposure to (or from) a counterparty. This netted value would then be margined or collateralized and the total collateral or margin posted would be much smaller than if it was treated on a trade-by-trade basis.

Regulators face a dilemma when proscribing reforms to the OTC derivatives industry – to rebuild public confidence and curb any excessive practices – while understanding that the next potential credit crisis will probably result from a new product that offers higher returns than a highly regulated and standardized OTC derivatives market.

It is no coincidence that the pace of new derivative product innovation has slowed significantly from its heyday in the early 2000s. The recovering economy and availability of credit plays a role, but more importantly, so does the current regulatory landscape. Banks will wait until legislators have completed the reform process before designing new products that will somehow escape burdensome regulation.

Staying the Course

In many ways, recent regulatory reform is a knee-jerk reaction to the scale of losses experienced in the preceding years. OTC derivatives bear the burden of new regulations. Financial institutions are cooperating for now, keeping in mind that their largest shareholders are often the same government agencies enacting the new laws. The public favors these regulations, so legislators will continue to forge ahead.

Key changes to be made should lead to:

• Improved market practices and the elimination of opaque and risky practices such as “Mark to Model” valuations
• Day-one profits and losses on a product with a lifecycle of five years
• Improved and augmented risk management practices, including more accurately measured counterparty risks
• Collateral that reflects risks and stems from high-quality assets

Nonetheless, regulators need to recognize that volatile financial markets are more interconnected than ever before, not only geographically, but also across asset classes. The equity, fixed income and loan markets are all intertwined with the OTC derivatives, short-term commercial paper and repo markets. Subsequently, commodities prices and interest rate levels are combined with currency markets. Understanding these connections, as well as the underlying causes of past failures, is the only way to properly risk-manage the financial industry. To do so, regulators will need to continually evolve in tandem with markets and trading products.

There are numerous challenges on the horizon. Political winds will shift and the public opinion of regulation will differ when investors seek higher returns. Macroeconomic factors, a period of extensive Quantitative Easing that has already taken place, resulting inflationary side-effects, a new election year in the U.S., an uncertain coalition in the U.K., the loss of a government powerbase in Germany, directly resulting from Eurozone instability and the bailouts of Ireland, Portugal and Greece, political turmoil in the Middle East and the recent disaster in Japan are all destabilizing situations that will continue to contribute to the uncertainty of the financial markets, which no amount of regulation can stop.