Regulatory reform is changing the face of global finances for good, but it is important the new rules do not sacrifice liquidity in the search for transparency.

Financial regulatory reform - including that of the over-the-counter (OTC) derivatives business - is starting to reshape global financial markets. In the US, the Dodd-Frank bill is the law of the land and the process of regulatory implementation has begun. The European Commission is slated to publish a draft law on OTC derivatives and measures to regulate naked short-selling of sovereign credit default swaps by October.

As reform efforts progress, it is important that the new regulatory framework preserves the flexibility, liquidity, cost-effectiveness and ease of execution that derivatives participants now enjoy. Simple, mandatory rules may lead to unintended and harmful consequences. These should be avoided wherever possible.

A clearer picture

Improving counterparty risk management has focused largely on centralised clearing for standardised contracts. While this will be mandatory in several months' time under new US law, the industry has already cleared some $235,000bn of interest rate and credit default swaps, and has torn up or compressed an additional $100,000bn-plus of derivatives contracts. The industry is working closely with clearing houses to expand the number of products eligible for clearing with an informal goal of more than doubling the volume of cleared products in the next two years.

Clearing houses should be an excellent means of reducing interconnectedness - the risk that a default of one bank leads to the default of other banks and market participants. But clearing houses need to be carefully managed and regulated lest they themselves create the systemic risk they were meant to eliminate. Clearing houses need to carefully plan to withstand the defaults of their members and such planning needs to assume defaults occur during stressed market conditions.

The International Swaps and Derivatives Association believes clearing is not for all participants or for all products. Many derivatives users will find clearing is more expensive and perhaps riskier than using bilateral arrangements. Those that use derivatives mainly to hedge market or balance sheet risks associated with their businesses should be considered for exemption from clearing. These entities should, of course, have the option to clear but must not be forced to do so. They did not suffer significantly in the Lehman bankruptcy and the cost of clearing - posting initial and variation margin and maintaining excess liquidity to meet future margin calls - is better invested in their businesses where jobs might be created.

Certain products cannot be cleared because, by their very nature, they are too complex to value with precision and too illiquid to ensure the clearing house is able to sell the positions upon the default of a member. Finally, regulators should be able to permit regulated entities to execute transactions that are otherwise subject to clearing on a bilateral basis if, in doing so, it actually reduces counterparty risk.

A question of liquidity

Putting derivatives transactions on exchanges or swap execution facilities (SEFs) may improve transparency but at the cost, perhaps, of reduced liquidity. What guarantee will there be that market-making will continue when clients are trading anonymously? We question why government bond markets remain OTC if users would be better served by restricting trading to electronic platforms. As the rules develop for SEFs, we caution authorities to examine carefully the impact on liquidity of their actions.

Capital and margin requirements should be sensibly constructed. Institutions that are exempt from clearing should also be excluded from mandatory margin requirements. Capital charges for uncleared swaps should be larger than those for cleared swaps but should not be set at punitive levels. Capital charges should be harmonised globally so that no participants have an unfair advantage.

Finally, we are puzzled by the US requirement of pushing certain derivatives transactions out of the banks. This is inefficient from both a capital and counterparty risk management perspective. In this instance, we believe global harmonisation is not appropriate.

Conrad P Voldstad is the CEO of the International Swaps and Derivatives Association

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter