The Reformation: All Change For OTC Derivatives
Braian Szwarcberg-Poch, Managing Director and Malavika Shekar, Senior Consultant, GreySpark Partners.
The OTC derivatives market is characterised as anonymous and opaque. Entering into an OTC derivatives trade means that risk exposure is to the other counterparty as much as it is to the market. Therefore, if one side of a trade is in the money, then counterparty risk increases. Counterparty risk increases because the opposite side to the trade is less likely to pay what is owed.
Prior to the global financial crisis, it was not common knowledge that the risk management ‘function covering counterparty risk was a mere ‘gentlemen’s agreement’ between some counterparties because Credit Support Annex documents covered trades but margin was not always called in a timely manner, if at all. It was largely viewed as unlikely that a counterparty to an OTC derivatives trade would warn an investment bank active in the market – like Lehman Brothers, for example – on their losing trades because doing so could potentially impact a future trading relationship.
But, in 2008, Lehman Brothers filed for Chapter 11 bankruptcy when liquidity became severely squeezed in the market. Suddenly, market participants trading with Lehman Brothers at the time found they held toxic portfolios of debt trades, and that everyone in the market was suddenly a creditor. The collateral damage of Lehman’s default was widespread and triggered the start of the global financial crisis.
In 2009, G20 leaders sought to mollify these failures of the largely unregulated OTC derivatives markets by agreeing to better regulate said markets. Crucially, the G20 agreed that:
- by the end of 2012, OTC derivative contracts were to become more standardized so that they could be:
- traded on exchanges or on electronic trading platforms;
- cleared through central counterparty clearinghouses;
- and by requiring that OTC derivatives trade data be reported to electronic trade repositories overseen by national regulatory bodies like the US Commodity Futures Trading Commission and the EU’s European Securities and Markets Authority.
The goal of these regulations is to make the OTC derivatives market more similar in form to a market for futures. One crucial factor driving this G20 initiative is that, before 2008, up to 70% of all OTC derivatives trades were already largely standardised.
What are the key variations in regulations between regions?
Although the G20 regulations aim to achieve the same end goal, the legislators and regulators in each country where the new rules apply differ in their approach to implementing the plans. Long term, the regulations that govern OTC derivatives trades will be consistent across all G20 nations and, eventually, also across developing countries. In the near-term, however, the main difference so far between the extent of new regulatory oversight and its practice was the timing of the implementation of the new rules.
The US was the first to move on this regulatory call to action with the passage of the Dodd-Frank Act (DFA) in 2010. The law was widely considered optimistic in terms of its implementation deadlines and, unsurprisingly, some of these deadlines were pushed back. For the US, being a first-mover on the G20 proposals came with some disadvantages and issues around extraterritoriality began to brew. The EU has followed the US through its current drip-feed implementation of the second iteration of the Markets in Financial Instruments Directive (MiFID) in an attempt to learn from mistakes made in the US promulgation of the DFA rules.
More importantly, the EU’s slower approach to implementation of the G20 rules benefitted the 28-member state bloc as OTC derivatives trading volumes increased when market participants tried to avoid being caught under the extraterritoriality clauses of the DFA, trading instead via Europe-based entities. The rules under the EU’s European Market Infrastructure Regulation – which is a piece of legislation under MiFID – are still fluid and developing, with mandatory trade reporting starting in February 2014 and with deadlines for central clearing not yet announced. Meanwhile, the nations within the Asia-Pacific region are benefitting from third-mover advantage in the implementation of OTC derivatives trading reforms. However, as a region, Asia-Pacific is a fragmented regulatory landscape, and regulators in each country there are setting OTC derivatives reform deadlines independently of one another. For example, in Australia, OTC derivatives trade reporting is mandated using a phased approach while the central clearing of trades is not yet compulsory.
How should sell-side and buy-side firms look to respond and be ready for national deadlines?
Globally, the sell-side and the buy-side alike should look to respond to the onset of new regulatory regimes governing OTC derivatives trading by preparing for their implementation as early as is possible. The trade reporting mandates in the EU and US require counterparties to produce a daily report to national trade repositories; these reports must include previously unreported data and include unique trade identifiers.
Compliance with these new rules is equally difficult for a wide range of counterparties outside of traditional sellside market makers and their buyside counterparties, and the new rules also apply to a range of other markets and products outside of the scope of OTC derivatives markets. Large investment managers are expected to increase staff headcount and upgrade risk management software to prepare for the mandates. Small investment managers will equally and proportionally need to make the same changes to continue trading. In Australia, anyone with an Australia Financial Services License must comply with some new regulations that, on a broad scale, would cover any party trading OTC derivatives barring corporations.
Preparing to centrally clear the majority of OTC derivatives trades is not a quick process, and all firms affected by the rules should take steps as early as possible to ensure they are not caught out by the requirements of their national regulatory regimes. Establishing clearing relationships and testing systems early, but then not putting live trades through until mandated is the ideal option. However, only a small number of OTC derivatives market participants globally have taken these steps so far.
Presently, trading in uncleared OTC derivatives is triggering extra capital requirements for banks under the Basel III accords, which they are – in turn – passing on to clients in the form of less competitive pricing. Buy-side firms can avoid these higher fees by complying with central clearing mandates as early as possible.