A paradigm shift lies ahead for the global derivatives market as impending regulatory reforms take shape. The European Market Infrastructure Regulation (EMIR), now working its way through the legislative process in Europe, and the Dodd-Frank, Wall Street Reform and Consumer Protection Act (Dodd-Frank) recently enacted in the US, promise to alter the fundamentals of how over-the-counter (OTC) derivatives are traded and administered. Even as investors await clarification about the overall framework in Europe and the final rules governing implementation in the US, they can be certain that the outcome will broadly affect their own strategic and operational decision-making. The larger ripple effect these changes will have on the derivatives space will also require attention as investors re-evaluate their risk and cost calculations.
Derivatives: Yesterday, Today and Tomorrow
The growing regulatory focus on derivatives is a reflection of their historical importance as part of an investment strategy and their perceived (though not undisputed) role in the recent financial crisis. It is helpful to bear both of these perspectives in mind to understand the proposals for reform that policymakers and regulators are currently putting forward.
Long used for hedging risk, derivatives have also been effective instruments to support high-growth investment strategies, with OTC trades representing more than US$600trillion in notional value at the end of 20101. Yet the size of this market also accentuates the challenges it posed to systemic risk even before the financial crisis. Among the issues arousing greatest concern have been its uneven clearing and settlement infrastructure, post-trade processing difficulties, and lack of transparency regarding terms of trade, potential losses and market value. Current reform efforts are aimed at addressing these challenges while preserving derivatives’ fundamental utility for investors and end-users.
Although the overall framework for the regulatory initiatives moving forward in Europe and the US is clear, many details are still in flux. Nonetheless, both EMIR and Dodd-Frank share broad similarities. Each mandates clearing through central counterparties (CCPs), imposes capital requirements for all trades, including higher amounts for non-cleared transactions, requires that funds for margin and collateral be maintained in segregated client accounts, and establishes certain reporting provisions to improve transparency. By comparison, today most bilateral trades are executed through dealers and concluded privately. They also frequently require lengthy manual processing, rely on inconsistent collateral requirements negotiated by the parties to a trade and entail non-transparent counterparty risk.
Although the mandate in Dodd-Frank covers trades declared ‘clearable’, EMIR, which was first proposed by the European Commission (EC) in September 2010, takes a more holistic approach, sweeping all transactions that meet the eligibility standards into its purview unless otherwise exempted. It defines eligibility in terms of whether a class of derivatives has been declared subject to clearing, and provides for limited exceptions for nonfinancial entities that fall below a yet to be determined threshold. Meanwhile, pension schemes may be granted a transitional period before full compliance may be required. In addition, current language in EMIR suggests that CCP membership may be subject to stricter criteria than those included in Dodd-Frank. Derivatives trading in Europe is also the subject of a separate review that will be part of the review of the Markets in Financial Instruments Directive (MiFID) later this year.
In the US, the majority of the Dodd-Frank provisions related to derivatives are not scheduled to take effect before January 2012, with the implementation date still uncertain given delays in the rulemaking process. Meanwhile, EMIR still faces further legislative review that may result in further changes to the existing proposal. While the final results of both processes are likely to converge, investors will need to stay alert of possible differences.
As policymakers and regulators hammer out the details, it is clear that derivatives investors and the financial services industry that serves the derivatives market are about to enter a new world. For investors in particular, it is critical to consider the implications of mandated clearing, derivatives-related costs and enhanced transparency on their business models. Perhaps even more important will be the question of how, amid shifting perceptions, derivatives reforms might lead to unintended consequences.
Living in a Cleared World
The derivatives space has been moving toward exchange-like clearing over recent years, even for OTC trades. Reform initiatives clearly look set to accelerate that trend. With new rules in place on both sides of the Atlantic, estimates of the proportion of total trades likely to be eligible for clearing vary from between 60% and 75%. What might be the effect?
Investors may benefit from new clearing rules in several specific ways, once the market has absorbed the coming changes, including:
- The designated CCPs’ assumption of credit risk by, reducing the impact of default by individual counterparties.
- Greater market consistency as a result of centralised trading data, such as valuations and margin calculations.
- Evolving standardisation of derivatives instruments, enabling straight-through processing (STP) and other operational efficiencies.
- Significant risk mitigation resulting from consistently applied margining requirements.
Despite the mandate to clear, a substantial portion of this market will still consist of bilateral trades. Even non-cleared trades, however, will be subject to mandated collateral management, potentially influencing investment decisions. In addition, trade data repositories will collect data on bilateral trades, shedding considerably more light on them than is the case today.
While it is currently difficult to assess just how this shift to clearing will affect the overall market, investors can safely assume that a number of variables will determine the impact. These include the range of instruments granted eligibility for clearing, the workability of the new rules and the market’s success at implementing them. It will also be important to gauge how rules that favour cleared over non-cleared trades will influence investor decisions.
A New Cost Calculus
As investors anticipate a clearing-dominated OTC market, they face large unknowns about costs. The emerging infrastructure to accommodate clearing will engender a range of fees to support the services provided, although subject to evolving conditions. At the same time, investors may see offsets through transparent pricing and narrower spreads reducing the costs of the securities traded.
Of particular concern to investors will be the costs incurred as a result of rules governing margin and collateral. In both Europe and the US, entities entering into cleared trades will be required to post initial and variation margin to their clearing member, to help mitigate risk. Mandatory collateral or increased capital will also apply to non-cleared trades. Aside from the direct costs of the additional capital needed, investors can expect further knock-on effects, e.g. as rules defining eligible collateral lead to a growing demand for collateral considered acceptable either by CCPs or market counterparties for non-cleared trades. Since this ‘acceptable collateral’ is likely to be either cash or government-grade securities, the market may see a shortage of such assets. Investors will also face the challenge of coming up with solutions for managing their margining and collateral needs.
Transparency: A New Window into the Market
The advent of mandated clearing, along with new reporting rules, will signal a dramatic increase in transparency. With the market providing crucial data about trades – terms, holdings and, above all, exposures – risk management becomes more straightforward. In addition, as previously noted, transparency in order execution may have a soothing effect on spreads, leading to fairer pricing, a more orderly flow of capital in the market, and greater accessibility for investors. Certainly new informational tools can influence decision-making and improve trading performance. It is too early to tell exactly in which direction they may steer investors.
As today’s derivatives framework evolves to comply with the emerging regulatory environment, investors will face the operational challenge of ensuring that their administrative infrastructure can support their trading needs throughout the investment life cycle. While automation will play a larger role, middle- and back-office work flows will shift in ways still difficult to predict. Above all, infrastructure will require the flexibility to adapt to changing rules and cross-border complexity.
Third-party providers will increasingly offer investors solutions in meeting this challenge. Leading custody banks, with deep experience in tracking and managing collateral, for example, have the resources and expertise to offer end-to-end servicing capabilities for derivatives. Moreover, independent providers can serve as trusted partners to help investors navigate their way through the rapidly shifting derivatives space.
Amid the unknowns about the changes ahead, investors can be certain of their scope. Once derivatives trades move to clearing, they will behave much more like exchange-traded instruments. Investors will, for the most part, deal with clearing houses and clearing members rather than individual counterparties. Absorbing the market implications of this shift will require time. It will also be essential to remain vigilant for the unintended consequences that the new regulatory regimes in Europe, the US and elsewhere may trigger. Altered investor perceptions and uncertain costs will likely influence investment strategies and decisions, with as-yet hard to fathom effects on overall risk calculations. For investors and regulators alike, a game-changing chapter is about to begin.
1Semi-annual OTC derivative statistics at end of December 2010, Bank for International Settlements.
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