Panelists taking part in a Sifma conference last week said they have made progress in getting some US regulators to take a more pragmatic approach in reforming the over-the-counter (OTC) derivatives market. However, securities firms will still have to brace themselves for the IT management challenges, new capital allocation and margining burdens, and revamped business practices to come.In preparation for the overhaul, firms have been dedicating staff and hiring new employees to prepare multi-faceted responses to the OTC overhaul to come, panelists said. “We’ve been having SEF (swap execution facility) readiness meetings for a year-and-a-half,” said panelist Lee Olesky, CEO and co-founder of the Tradeweb, an OTC, multi-asset class electronic marketplace. Once the new regulations take effect, Tradeweb intends upon becoming a SEF, Olesky said.
Another panelist William C. Thum, senior derivatives transactional and regulatory specialist with investment manager Vanguard, said the Sifma asset management working group has been effective in getting regulators to move from a fairly conservative approach to rules-making to a more pragmatic attitude.
Thum said that there have been some shifts among the regulators in key areas such as: an emphasis on risk reduction rather than a main focus on revamping trading practices; the importance of clarity for data reporting especially as it affects middleware providers and new market entities such as the forthcoming SEFS; and a harmonization of global regulatory efforts.
Vanguard has also been pressing for a phased-in approach to new regulations rather than the aggressive schedule of the regulators. (Last month, the CFTC moved to allow six more months before implementing key regulations spawned by Dodd-Frank.) The phased-in approach is not for Vanguard’s benefit, Thum stressed. Rather “the fear is that firms like ours will get to the finish line while [smaller firms and new market entrants] will be constrained and shut out of the market” by the regulators’ tight time frames, he said.
All players—either new to the OTC market or already established—will find the IT management issues caused by the reforms to be a major challenge, said panelist Thomas Levy, managing director and head of marketing for OTC clearing at Morgan Stanley.
The move from bilateral to multi-lateral transaction processes as well as the many network connections required will be daunting. “This is a technology-heavy undertaking,” he said. For instance, the brave new world of OTC trading will require new communication protocols and possibly customized links to broker/dealers, futures commission merchants (FCMs), US and non-US central counterparties (CCPs) and clients.
In addition to the new links to clients, firms will need a greater knowledge of what their clients have as far as infrastructure, Levy said. Clients will also have to be guided through “the greatest traffic jam we’ve ever seen.” The toll for the traffic jam in terms of new margining will be “four to five times higher” than the collateral allocated for bilateral transactions, he said.
The greater margining and capital requirements will lead to tradeoffs, said Luke Zubrod, a director overseeing global interest rates and currencies at risk management advisor for Chatham Financial. One likely scenario is that firms trading in the OTC markets to come will have to choose between standardized OTC derivative instruments that will require them to take on any mismatching and hedging responsibilities or opt for “more expensive,” customized derivatives. The new world of multilateral OTC trading will become more complex as the incumbent bilateral business “will diminish substantially,” Zubrod said. A great deal depends on the magnitude of the transition from closed, bilateral transactions to open OTC trading, but Zubrod said he expects a rapid decline over the next two to four years.
A great deal will also hinge on when US and non-US regulators implement their new rules, Olesky said. If regulations take hold at different intervals, there will “an element of competition between geographies,” he said.
Overall, international harmonization has been “quite a challenge,” said Don Thompson, managing director and associate general counsel at JPMorgan Chase & Co., and panel moderator. “There’s the very real possibility of different sets of rules in Europe and non-US jurisdictions,” Thompson said. He added that unfortunately the disharmony starts at home with the CFTC and SEC regulators crafting different sets of regulations that lead to sometime contradictory objectives.
“You run the risk of achieving one public policy objective at the expense of another,” Thompson said. If these cross purposes cannot be resolved, it will lead to competitive disadvantages for US firms.
When asked by an audience member if the European regulators are intentionally letting the deadlines slip, Thompson said that he and the panelists would not assume that regulators are acting in bad faith, and that all sides want to reduce market risk and increase market efficiency. “We were there in 2008 and we don’t want to be there again,” he said about the Great Recession. “We’re trying to build the plane while it’s on the runway.”
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