Joe Cassidy, Deutsche Bank’s global head of prime rates brokerage and clearing, considers how the over-the-counter derivative landscape is evolving and what market participants can do to prepare for the changes.

While the one-year anniversary of the passing of the Dodd-Frank act is certainly a milestone, the end game is still some way away. Indeed, with June’s announcement that the implementation of new derivatives trading rules is being delayed by six months, it appears that it will still be some time before the current uncertainty is resolved. Reaching a consensus on proposed changes and developing the relevant infrastructure in order to enable all parties to conform to the draft legislation is taking some time, and the necessary technology platforms and processing models have yet to be built.

One further factor contributing to the delay has been the shift in the US political landscape since the legislation was drafted. The Democrats’ loss of the House of Representatives and a large number of Senate seats in late-2010 led to more dissenting voices in Congress, and an increasing number of legislators are prepared to push back against the implementation of these regulations.

Slipping behind

These developments in the US are being keenly observed in Europe, where similar regulations are also being drafted and implemented. While the European time-line was also perhaps too ambitious – and has, unsurprisingly, also slipped behind schedule – lessons have been learned from the surfacing of unforeseen consequences in the US and draft regulations have been amended as a result.

Dodd-Frank, the European Market Infrastructure Regulation and the Markets in Financial Instruments Directive II are certainly all key components of current regulatory reform in the over-the-counter (OTC) derivatives space. However, in order to obtain an accurate picture of how the costs of OTC trading will change in the coming years, market participants need to consider these in conjunction with other changes, such as the Basel III accords and the new Capital Requirements Directive. Indeed, the potential consequences for different market participants will vary greatly depending on a range of factors – such as bank/non-bank status and the perceived riskiness of the activities engaged in – and some institutions may secure temporary or complete exemptions.

Yet, at least in the short-term, it is the banks that will have to be the early adopters of new rules and regulations, so it is these institutions that need to give the closest consideration of which strategy to adopt in this changed marketplace. Having said this, there is certainly no need to panic – substantive changes to existing practices are still some way off and banks have time to consider how and where they invest in infrastructure, and whether they self-clear or use third-party clearing (from other banks).

Transparency, reporting and risk

The forthcoming changes to existing OTC derivates practices pertain to three principal areas: price transparency, regulatory reporting and counterparty risk management. Regarding price transparency, liquid OTC instruments – for example, interest rate swaps and indexed-credit default swaps – will all end up being traded on regulated exchanges known as swap execution facilities (SEFs) in the US and organised trading venues (OTVs) in Europe.

While the market has been aware of these changes for some time, SEFs and OTVs are meeting some resistance from buy-side institutions. This is being driven, at least in part, by concerns regarding the amount of information that these participants will now have to reveal when desiring to trade. While, previously, buy-side users could choose who to call for pricing, they will now have to disclose their intent to the market when participating in an exchange scenario.

Concerns regarding information leakage are also contributing to some buy-side resistance surrounding the new rules on regulatory reporting. All OTC products – whether cleared on an exchange or not – will be subject to these rules, and controlling who sees this information and to what purpose it is used is key to protecting the integrity of end-clients, market makers and service providers.

All change?

So what do these changes mean to banks participating in the OTC derivatives space? Some institutions may be either excluded from becoming clearers – due to stringent capital or trading book requirements – or may choose not to due to concerns regarding the additional assessment risk associated with exposing themselves to multiple currencies. These banks that choose not to clear themselves may still seek to join a SEF or OTV, and publish their pricing through such a venue, but then engage another institutions to provide them and their clients with clearing services when required.

One issue here is that the models developed by the central counterparties (CCPs) have predominantly been targeted at large investment management firms and hedge funds rather than taking into account the needs of regional and local banks. Indeed, the legal structure associated with the CCP role is not as efficient as it could be when supporting the needs of these banks and their end clients. This is, at least in part, due to the Pareto principle at work in this market – a large proportion of the risk is situated with several large players, while there is a long tail of institutions and actors that could potentially be considered exempt from the new rules.

However, even if these institutions’ usage of OTC instruments is very small in volume terms, the regulator may take a view that their ability to withstand losses is also relatively small. And the validity of claims regarding actual usage, or otherwise, of OTC instruments will become clearer when all institutions become obliged to report their level of activity in this respect to the regulator.

Execution costs

Although we are still some way from a definitive answer regarding exactly what will happen to OTC derivates markets and how all types of institutions will be affected, one thing is certainly clear: all market participants need to start considering the changing end-to-end costs of execution. And this means looking at the combined impacts of derivative reform and regulatory capital reform.

While spread was once the key cost consideration, other potential elements now need to be looked at, including collateral cost (CCPs require initial and variation margin), regulatory capital and margining methodologies. One effect of these changes may be that some institutions decide that focused and bespoke OTC products have become too expensive, and they may opt to use listed products instead, even if this results in a tracking error and only provides a partial hedge.

Of course, obtaining a definitive view of what the changes will mean is currently impossible given that many aspects of the proposed regulatory reforms are still under consideration. Indeed, while we hope to have a more accurate picture of the situation in the US by the end of this year and in Europe by mid-2012, it is likely to take several years for the full implications to become clear as different aspects of proposed changes are implemented in stages.

However, what is certain is that price considerations will lead to new classes of derivative instrument emerging, probably hybrids of existing OTC products that will be less versatile and have different pricing characteristics. And adapting to these changed products and new regulatory requirements will have a knock-on effect for many institutions, altering the nature of their broader cash management arrangements and the efficiency of existing practices in this respect.

A key milestone

One year after the passing of Dodd-Frank, the key message for all market participants is that there is still a long way to go before the full effects of OTC derivative reform are felt. However, while institutions do not yet have to take concrete action in terms of selecting partners or building infrastructure, a careful consideration of the end-to-end costs of participating in these markets and the consequences for their broader cash management arrangement is crucial.

From Deutsche Bank’s perspective, we seek to remain at the forefront of industry thinking on this topic, engaging with the regulators and partnering with clients on how best to navigate the changing landscape. Of course, our ultimate goal here is to facilitate efficient asset/liability management, and to conform to regulation, and we continue to develop our armoury of solutions to assist clients with the challenges they face in this respect.

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