In accelerating the move to clearing, US regulators risk rushing out reforms for OTC derivatives that may do more harm than good. That was the thoroughly anecdotal consensus at FTF’s 3rd Annual OTC & Exchange Traded Derivatives Ops Conference in Chicago this past Monday.
Conference panelists and participants drove home that point and others as the regulators are not likely to meet their deadlines for the new rules, have yet to set priorities for the new world of clearing like establishing clearinghouses first, and still have much to define such as the Dodd-Frank mandated Swap Execution Facilities (SEFs).
The initial deadlines for new regulations were slated for July of this year but that now seems like wishful thinking. There have been several reports of regulators working long and hard to create a market structure almost from scratch. But, many of the new Congressional Republicans have been working just as hard to crush the regulatory overhaul. This could lead to a new limbo for all of the regulations to come from Dodd-Frank, not just the OTC clearing overhaul.
Some other key points were made at the conference:
• The fate of the OTC derivatives market (or any financial market) in the US should not hang on the whims of politicians pressuring overly burdened federal regulators. While the abuse of OTC derivatives contributed to the Great Recession, making these instruments the ultimate scapegoat will not erase past neglect by the regulators or the never-ending stupidity of politicians. And making OTC derivatives pawns in endless political battles could sink an industry by driving away liquidity.
• The regulators and the politicians have to stop making speeches and simply hammer out a realistic time-frame for OTC clearing. This should be a phased-in approach because this is a reset that will overturn business processes, challenge entrenched players and spur financial IT providers into action. All of that takes time.
• There will be multiple adjustments to come—new margining requirements, new clearing costs, refreshed IT infrastructures and a review of roles and partnerships—to cite only the top concerns. This will happen as firms vie for liquidity in a nervous market.
• The regulators have to do a better job of coordinating as they write their new rules. They have to avoid conflicts and loopholes that could create arbitrage opportunities for those who would exploit discrepancies between the US and non-US markets for OTC instruments, as pointed out by a panelist from a major asset manager.
The bottom line is that despite Dodd-Frank, the OTC industry is in a holding pattern with the same systemic risk that it had in2008 as noted by Jamie Cawley, CEO of Javelin Capital Markets and co-founder of the Swaps and Derivatives Market Association (SDMA), which is the subject of this month’s FTF profile.
Stephen Bruel, an analyst for market research firm TowerGroup, says in our profile of the SDMA, that the jury is still out as far as the wisdom of the compressed time-line for OTC clearing. Bruel also argues that innovation led by regulatory fiat is “less effective” than market-led efforts, and that innovation remains the deciding factor. He says that if we get to OTC instrument clearing, innovation, in terms of market color, research, and strategic advice, provided by broker/dealers, clearing brokers and execution brokers will make all the difference.
I agree that innovation is more powerful than over-reaching regulations. We sorely need it now as the industry painfully transitions from survival mode to the next chapter. The good news is that innovation is not at a complete halt.
Despite tough times, we have seen cloud computing take hold, mostly because it brings together virtualization, on-demand computing, web services and high-speed networking. In addition, there appears to be an immediate marriage between the cloud and disaster recovery that has given firms more options for their DR and business continuity strategies.
Mobile devices such as tablets and smartphones represent another innovation—particularly for the wealth management sector—that is challenging firms to rethink their IT infrastructures and even the boundaries of their front, middle and back office structures. On the less glamorous storage front, write once, read many, or WORM, solutions have taken hold because the regulators (again!) require data to be stored unmodified and easily accessed.
So, while it’s true that innovation can be imposed by regulators, it’s better that financial services firms and financial technology vendors take back the upper hand in the creation of new financial instrumentation and services and the IT solutions needed to support them.
I would strongly urge that we return to this tradition and get the government out of the business of innovation ASAP.
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