The derivatives industry is facing the biggest regulatory upheaval in its history. Politicians are set to clamp down on what they view as an opaque business that played a central role in the financial crisis of 2008. The US is leading the stampede with a heavy-handed approach to pushing industry reform. Although the changes are only just beginning to take shape, corporates and other end-users are lobbying hard to ensure that new legislation is not so severe that it ravages their cash flows and prevents them from adequately managing their business risks.
Even before the financial crisis dragged the reputation of the derivatives market through the mud, the US was pushing for a number of regulatory changes. It wanted to increase electronic confirmation rates, and had been working with the G15 group of banks to achieve new targets. But in September 2008, the spotlight firmly focused on the role that derivatives played in the near-collapse of AIG and Lehman Brothers. That catapulted derivatives reform to the top of the government’s agenda.
Many market participants view the response as a knee-jerk reaction, based on the inaccurate assumption among politicians that the market primarily represents speculative trading between financial institutions rather than real risk management activity by corporates.
"When you look at the number of counterparties who are dealers, banks or hedge funds it is a small percentage of the overall OTC customer base when compared to the number of corporates, sovereign, municipal and pension fund management counterparties who use these markets as they seek to hedge real risks in their activities," said Andrew Hudis, managing director, swaps trading at Goldman Sachs.
The first plans were laid out in May 2009 when US Treasury Secretary Timothy Geithner outlined a regulatory framework for the OTC derivatives market. It envisaged all standardised OTC trades be moved onto regulated exchanges or regulated transparent electronic trade execution systems, and all trades not cleared by central counterparties (CCPs) reported to a regulated trade repository. In addition, the two regulatory bodies, the Securities and Exchange Commission and the Commodity Futures Trading Commission would set capital and margin requirements for industry participants and would retain the right to set position limits.
“There has been an amalgam of bills over the last nine months covering derivatives reform, with three or four pieces of major legislation. The Geithner proposal is likely to be the base for any final bill,” said Michael Stein, global head of government relations at Morgan Stanley.
In August, the US Treasury committee sent a draft bill of new derivatives legislation to Congress, but with healthcare reform dominating the US agenda through 2009, new legislation should be finalised in 2010. Other countries have followed suit. In Europe the European Commission recently concluded the consultation period following publication of its communication document ‘Ensuring Efficient Safe and Sound Derivatives Market,’ with draft proposals for regulatory reform expected in October.
Most market participants, and even most politicians and regulators, concede that derivatives were not actually responsible for the financial crisis. Yet several high profile scandals involving the use of derivative instruments have convinced many industry participants that derivatives reform is a positive and necessary development that will underpin confidence and ensure a healthy future for the industry.
"Most derivatives professionals view the legislation as leading to beneficial changes to the industry as a whole. It causes firms to redirect resources and the net result is positive if it forces greater take-up of existing infrastructure tools that were already built by the industry itself," said GS’ Hudis.
Following the loss of a major counterparty in Lehman Brothers, counterparty risk is at the centre of reform, with a shift to CCP clearing forming the basis of the new landscape. While CCP clearing may be welcome for high volume products like CDS, some warn that clearing and exchange trading are unsuitable for many of the products that are traded by end-users.
“What products are suitable for clearing should be determined by the clearing houses,” said David Clark, chairman of the Wholesale Market Brokers Association, an industry body representing inter-dealer brokers. “End-users of [products] that are not suitable for clearing should not be penalised, otherwise the outcome will be the exchange of systemic risk for basis risk.” (For more on CCP clearing see following article, Clearing the way).
European corporates are taking careful note of developments across the Atlantic, as the European reform effort lags a few months behind that in the US. The EC appears to be taking a more consultative approach with greater focus on standardisation of processes rather than products.
“There are already two major pieces of legislation in place covering derivatives – MiFID and the Market Abuse Directive - what we are looking at is filling in the gaps,” said Maria Velentza, head of the securities market unit at the European Commission. “We favour solutions that are alternative to legislation and we may use a mix of policy tools to achieve the goal. Any new legislation will be justified and subject to cost benefit analysis.”
Throwing the baby out with the bath water
European corporates have been quick to highlight their concerns through the EC’s consultation period. Most of these centre on the fact that typical corporate hedging activity poses no significant risk to the system.
“If politicians are trying to limit systemic risk, then they should address only those transactions that threaten systemic risk. We believe that non-financial companies using derivatives for hedging are not systemically significant. Hedging is limited to real business activity and can’t be pumped up like speculative activity,” said John Grout, policy and technical director at the Association of Corporate Treasurers.
“We hope that Europe takes a more substantive rather than an accounting based approach to new legislation,” he added. “It would be better if that legislation excluded wholly the non-financial sector.”
Under the Geithner proposals, much of the non-financial OTC derivatives activity would be excluded from regulatory reform, but US regulators CFTC and the SEC are pushing for more stringent legislation that would ensure no exclusions. Any requirement to move all standardised contracts onto regulated exchanges or central clearing venues could leave corporate end-users facing a hefty cash burden. They could be forced to put up working capital as margin and be required to find additional cash to support any downward movement in positions.
“If a company has to put up cash collateral it turns its hedge transaction into an immediate cashflow, which will not match the timing of the counterbalancing commercial cashflow being hedged – perhaps by many years. This introduces a serious cashflow problem, potentially nullifying much of the benefit of the hedge,” said the ACT in its response to the EC’s consultation document.
ACT members are particularly worried that in the current economic environment, many companies are already operating under serious cash constraints. There is little availability of additional funding to create any headroom. Where such a company is required to find additional cash to meet a margin call, it could be the final event in triggering the collapse of the company.
Even exchange operators, which stand benefit from an OTC shift to exchange trading, are concerned. They warn that a heavy-handed regulatory approach could push derivatives trading away from the US altogether and into offshore light-touch regulatory havens.
“Commodity and financial futures markets today are global, and much of the price discovery that today occurs in the US could easily shift to foreign markets,” warned John Damgard, president of the Futures Industry Association. “The result would mean less liquidity and more price volatility in the US for both exchange and OTC markets.”
Some market participants believe that governments have simply got it wrong in labelling the derivatives market opaque. Inter-dealer brokers stress their post trade processes offer much of the information provided by exchanges. As regulated entities, IDBs report trades to regulators and provide OTC transaction data to quote vendors with a maximum delay of 60 minutes.
“OTC markets have as much transparency as regulators want to see, it’s just that derivatives lack a benchmark product to highlight that. IDBs are producing all sorts of information on products and prices, and if anything there is too much information rather than too little,” said Alex McDonald, CEO of the WMBA.
“If transparency means knowing what individual positions are, then IDBs aren’t in a position to provide that data, they can, however, provide information on price and volume of OTC transactions. Furthermore, WMBA remains in a position to provide regulatory authorities with aggregated price and volume transactions across all OTC and derivative markets if required,” he added.
There is a long way and many hearings to go before the process reaches completion, but the outcome could represent the biggest shake-up of the derivatives market ever seen. Alternatively, by the time the proposals morph into actual legislation, the final impact on derivatives users could be significantly lower than many fear.