OTC derivatives legislation and clearing reforms understandably have European and US market participants scratching their heads about what this "sea of change" has in store for them and the future of OTC markets.
David Felsenthal, a partner at Clifford Chance LLP, has given the matter some serious thought, and provides some guidance in his January 14, 2012 post at Harvard Law School's Forum on Corporate Governance and Financial Regulation.
According to Felsenthal, the reforms being considered focus primarily on transparency about on positions and exposures of individual firms in OTC derivatives, a transparency sorely missing during the financial crisis.
In an attempt to combat this problem, the regulatory measures share a certain amount of common ground. Put simply, they aim to improve transparency by requiring participants to disclose more information about the positions they hold. They also aim to reduce risk through changes to clearing and collateral requirements. Specific measures in the proposed regulation include reporting and clearing obligations for eligible OTC derivatives, measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives, common rules for central counterparties (CCPs) and for trade repositories, and rules on the establishment of interoperability between CCPs.
The focus on transparency is not in itself surprising, though as usual the devil is in the details. According to Felsenthal, the most likely areas of concern are
- lack of clarity,
- cost and competitiveness issues,
- variability of the implementation timetable between juridictions,
- unintended consequences.
The implementation timetables are particularly troubling. The US timetable has shifted widely, and the EU efforts have hit some roadblocks.
Sitting alongside these uncertainties is the variability of the implementation timetable. The US is not that much further on than six months ago, with little in the way of solid implementation dates. We believe that the regulations on mandatory clearing will be the first to be implemented, but this looks to have shifted back to mid-2012 and that can still only be a guess. This would bring them into the same proposed implementation timescale as new rules under Volcker requirements (discussed later) which are scheduled for July 2012.
It’s a similar story in Europe as the extended ‘trialogue’ between European Council, Commission and Parliament means that the European Securities and Markets Authority’s (ESMA) ‘fleshing out’ of the EMIR framework is being held back. The prospect of implementation by the end of 2012 looks challenging. In addition, CRD4 and MiFID II have their own timetables, with the former expected to apply from January 2013 and the latter currently likely to apply from the end of 2014 following a two-year transposition period.
Given the issues legislators and regulators are wrestling with, the shifting implementation dates are entirely understandable. Crafting regulation of OTC derivatives that effectively handles extraterritoriality (i.e., how to treat domestic versus foreign counterparties and institutions) has turned out to be particularly challenging, as has managing the overlap and consistency of regulations between jurisdictions. These two issues are key to preventing regulatory arbitrage, and effective combatting risk contagion.
As far as operational regulation, Documentation and collateral segregation issues abound with many market participants disagreeing about the best way forward.
In terms of clearing agreements for end users, there is a trend in the US towards the use of existing futures brokerage documentation, but with an OTC addendum. However, some are questioning whether this method, though relatively straightforward, is appropriate. Many in the dealer community are used to the bilateral agreement so it seems the obvious route, but isn’t the whole point of the cleared world that you don’t take risk on your counterparty? In which case, do you need this sort of agreement with them?
Perhaps the most contentious issue is the segregation of collateral. In the US, client collateral is traditionally held on an omnibus basis by the futures brokerages, with some scope for them to reinvest. The collapse of MF Global has further heightened calls for client collateral to be kept separate and transparent for each customer – although it could lead to increased cost for end users.
Felsenthal also sees issues presented by the Volker Rules and their implementation in the US, and discord amongst the EU players on a whole raft of issues, including platform trading obligations, and new short selling regulations, which will require disclosure of net short positions in shares and sovereign debt.
While the potential effects of OTC derivatives reform on day-to-day activities may be easy to identify the broader effect remains to be seen as governments and regulators hash out the details. This is clearly an area OTC market participants should watch closely both for opportunities to comment and influence its direction, but also for areas of potential business opportunities.