A deluge of regulatory changes aimed at reducing systemic risk and ending too-big-to-fail across financial markets has left buy and sell-side participants struggling to make business decisions as they digest the impact of the crippling capital regime and a slew of corporate governance and conduct changes.
Speaking on a panel at ISDA’s AGM in Montreal today, fixed income business heads called for greater clarity over new rules as they prepare for implementation of additional requirements that are set to take effect over the coming years.
“Although we’re coming towards the end of the rule enactment process, we’re only 50% through implementation and we won’t be through with the changes until 2020,” said Jonathan Hunter, global head of fixed income and currencies at RBC.
“We’re not actually seeing as much fragmentation as we might expect given the magnitude of the changes, but the fragmentation we have seen is about the cost piece and it’s making for tough decisions that might result in more fragmentation further down the road,” said Hunter
Increased capital requirements stemming from a range of regulatory initiatives including leverage ratio, Basel III, the Fundamental Review of the Trading Book and bank stress tests, combined with new governance and conduct changes under Dodd Frank, the European Markets Infrastructure Regulation and MiFID II have hit dealers at a time when the overall fixed income wallet is shrinking.
It is a situation that some believe contradicts the key regulatory aims of reducing systemic risk in the wake of the crisis.
“Although the capital rules make things safer on an individual entity basis, when taken together in aggregate it makes the market less safe,” said Jonathan Hall, advisory director at Goldman Sachs.
“Costs are going up and that will either force bid/offers to widen, or people will fully or partially exit some businesses. At the moment, we’re seeing mainly the latter as bid/offer spreads have remained pretty tight in liquid businesses,”
Structured solutions businesses and single name credit default swaps have been among the first to witness dealer exits, but while some larger markets have seen little bid/offer impact, the depth of liquidity is an ongoing cause for concern as dealers are forced to slash inventory amid rising capital charges against gross notional exposures.
“It feels like there has been a big increase in pro-cyclicality with the lack of liquidity. We’ve had days when the Treasury market and Treasury repo has suddenly vanished,” said RBC’s Hunter.
“Things might have felt really bad in 2008 and 2009, but the shock absorber was there. We’re very concerned about the unintended consequences of the new capital regime as that shock absorber won’t be there next time.”
For buyside participants, the uncertainty is creating a headache as they struggle to gain clarity over which products will prove to be unprofitable in the new regime.
“It’s becoming much harder to define what those additional costs are and for the business to figure out the drivers of those costs,” said Charlie Mulhern, director of fixed income operational risk at Wellington Management Company.
“It’s hard for us at the buyside to get transparency on those costs and make good business decisions.”
Dealers also raised concerns that the new regime is piling additional risk onto buyside firms.
“Banks are reducing risks but that risk doesn’t disappear, so end users end up taking more risk,” said Elie El Hayek, global head of rates credit and emerging markets at HSBC.
“When it comes to derivatives banks are taking less basis risk but that is simply moving to end users. We see lots of corporates no longer hedging cross currency risk.”
However, the panellists noted some bright spots in the new regime, in particular on transparency, standardization and harmonization.
“The industry has come a long way on transparency and there is much more dialogue than there was in 2008,” said Rich Herman, head of global fixed income and currencies at Deutsche Bank Securities.
“Standardisation is critical to deal with basis risk and deal with the cost of trading different instruments and the market has come together to compress swaps exposures in a way that didn’t happen before.”