Clouded by uncertainty

IFR Review of the Year 2012
9 min read
Spencer Anderson

Users of derivatives, both in the banking industry and the wider world, have spent months gearing up for the profound changes in regulations that 2013 will bring. But as implementation of the changes comes ever closer, room for considerable confusion remains.

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A profound change for over-the-counter derivatives trading will take place in 2013. With the implementation of Dodd-Frank in the US and the European Markets Infrastructure Review, there will be a massive increase in transparency and a reduction in naked risk. OTC trades, with a few exceptions, will be required to be centrally cleared, traded via electronic platforms and reported to central depositaries.

But while the regulations were put in place with the intention to create more transparency and stability, there remain a number of unresolved questions that will play out in 2013. One main issue appears to be a lack of harmonisation between the European and US reforms. With most banks operating in multiple locations, those in charge of banks’ efforts to comply with regulations are uncertain which rules apply to which activity in which location. Consequently, there are widespread concerns that many firms will simply not be ready for implementation.

Perhaps most crucially for the wider economy, the new rules are starting to attract the attention of non-financial users of derivatives who claim that EMIR and Dodd-Frank will cripple their liquidity and ability to manage various risks, such as currency or interest rate exposure. Like many of the banks, they too are uncertain about how the rules will affect their businesses.

“If I trade in the UK, but my client is in the US, which rule applies?” asked a banker at a large European investment bank based in London. “[Regulators] tell you that they have this sorted out, and we will avoid situations of double jurisdiction, but I’ll believe it when it happens.”

Clear as mud?

It is a question that many in the finance industry are asking, despite the European Securities and Markets Authority stating that they have been clear and upfront about this issue.

“We’re making sure the market is prepared and are planning everything that is needed for the process,” said Fabrizio Planta, the rapporteur of the post-trading standing committee at ESMA. “At the end market participants will have more than six months to be ready for EMIR and they can already start doing preparation work.”

However, bankers argue that regulators are in denial about what could go wrong.

One example that many pointed to was the difference on the amount of participants needed for a transaction on a request-to-quote basis. If, for instance, a hedge fund wanted to trade a credit default swap on a request-for-quote basis they would send an order to market-makers and select the ones they send it to. In the US they are required to send it to at least five market-makers, but in Europe, at least for now, there is no such requirement.

Another example of the problematic nature of enforcing cross-border regulations recently surfaced at a meeting among international regulators. It was discovered that French banks signing up to be swap dealers in the US would be required to give disclosures and allowances to the Commodity Futures Trading Commission, something that would be in violation of European and French privacy laws. While the CFTC is said to be looking for a solution, it highlights the numerous challenges that could arise in 2013.

A report published at the end of October by the Financial Stability Board, a body established to promote the implementation of effective regulatory policies, on the progress of the implementation of OTC derivative reforms said that decent progress was being made at the national level, but that the largest concern was regulatory uncertainty – both for national regulators and financial firms.

With only two months before the regulations are set to be enacted, the FSB warned that regulators still needed to identify conflicts, inconsistencies and gaps in their national frameworks and the cross-border application of the rules.

“The FSB’s review of infrastructure readiness found that the expansion of infrastructure use has plateaued,” the report said. “Infrastructure providers cite uncertainty over the future regulatory framework of products and participants that mandatory requirements will cover and the potential for cross-border regulatory differences and overlap. Progress to date in cross-border discussions has been slow. This risks delaying the full and timely implementation of the G20 objectives.”

“There is still a lot of uncertainty and even in the US where the process is further along, it’s still not clear what the final trading rules will look like”

The report noted that a “number of jurisdictions” have not yet explained how they will deal with regulators in other countries. “With the end-2012 deadline for reforms imminent, individual jurisdictions that have not yet done so need to urgently set out their proposed cross-border approach, not least so as to enable issues of international consistency between jurisdictions’ approaches to be identified and addressed.”


Financial firms are doing their best to prepare for the rules, but there is only so much they can do until they actually know what the playing field will look like. That is made particularly difficult, because, in many instances, the best the banks have to go on at the moment are draft rules. While these are expected to closely resemble the final rules, it adds an element of uncertainty to their businesses.

“There is still a lot of uncertainty and even in the US where the process is further along, it’s still not clear what the final trading rules will look like,” said James Rucker, a credit and risk officer at MarketAxess, a trading platform and data provider. “All we can do is assume that the final regulations will look much like the draft set of rules. That’s the basis upon which we’ve been making our preparations and it’s the only basis upon which we can proceed.

“If we were to wait for the final legislation to come out we wouldn’t have time, and if the rules turn out to be very different than are currently expected then arguably it could prove difficult for us to make the necessary changes in time.”

The real world

Many bankers and traders say the most damaging aspect of the reforms is the impact it will have on the real economy, particularly for their clients and companies that use derivatives to manage their risks. It might be a self-serving argument, but it is also something that corporates themselves have taken notice of, and they have been actively lobbying for easier rules.

Corporates actually managed to win a significant concession in the regulations – an exemption of the need for a trading platform for some of their trades. However, despite the exemption, they still appear nervous and above all unsure of what the exact rules will be.

Samantha Hill, corporate treasurer at Network Rail, was critical of the new rules for these exact reasons. She says her firm’s situation, where their liabilities are guaranteed by the UK government, puts them in a better situation. But she is convinced that EMIR will be challenging for a number of firms as well as her own.

“It’s still a bit vague,” she said. “There is supposed to be an exemption for corporates, but if you are a frequent user they have thresholds. In theory, if you execute hedges then you should be exempt, so in theory we should be exempt, but they haven’t really defined what a hedge is yet.”

Regulators on both sides of the Atlantic insist they have been as straightforward as possible with their definitions, but it is a somewhat moot point when end-users, and ultimately those who will actually be trading the instruments in question, remain confused.

“I’m for this legislation in spirit, but it is when it starts impacting on us that we can see some problems,” said a corporate treasurer at an American automotive firm. “I understand how difficult a task they have, and to do something as wide-ranging and broad as they are it is difficult to get too specific. But they have left us with some concerns, and I guess we’ll only know how it will play out when the time comes.”