Friday, October 16, 2009

Derivatives Markets Rebound As Reform Recedes

Robust trading activity in OTC derivatives products likely to continue as reform momentum dissipates according to Oxford Analytica (via Research Recap):

Over-the-counter (OTC) derivatives, particularly credit default swaps (CDSs), were faulted as a cause of the credit crunch, most prominently in a June 17 speech by US President Barack Obama announcing his administration’s plan for financial reform. This led to calls in the United States and elsewhere to regulate the CDS market.

Regulatory outlook. Some of this pressure has been addressed indirectly by proposals such as the G20’s commitment to require all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms, where appropriate, at the latest by the end of 2012 — non-centrally cleared contracts would be subject to higher capital requirements.

The Obama administration has made a strong case for pushing to move ’standardised’ OTC derivatives transactions to organised exchanges, so as to benefit both from standardisation (and the expected price decreases that will follow), and centralised clearing mechanisms (which would replace the exchange as the nominal counterparty to the transaction, thus eliminating the lion’s share of counterparty risk). Unsurprisingly, the exchanges themselves support such moves and have positioned themselves to offer a broader product mix, and cross-border services

Yet different sources of opposition have arisen, even to such modest proposals. It remains uncertain whether the 2012 G20 deadline will be achieved, despite calls from such prominent officials as EU Internal Market Commissioner Charlie McCreevy for more rapid and meaningful standardisation of such markets.

Industrial companies. Within the EU, large industrial companies have emerged as an unanticipated source of opposition. The consequence of mooted changes would be to increase their costs, as they would be required to post margin to make such trades, which is currently not necessary:

  • Ironically, proposals are designed to reduce the systemic risk posed by financial institutions engaging in such trading (especially given its concentration in a handful of firms), but would have a strong cost impact on the industrial firms who use OTC derivatives for valid non-speculative hedging purposes.
  • Some industrial players have called for exempting industrial firms from margining and clearing requirements, but such a suggestion is impractical, if not conceptually impossible.
  • Yet if reforms proceed, industrial firms may attempt to move their trading offshore to reduce such costs, and away from stringent regulation, thus reducing another major motivation for reforms.

Financial institutions. While some firms, such as JP Morgan Chase, have opposed changes upfront and outright, more serious debate will centre on what constitutes a ’standardised’ contract, with the industry pushing for narrow interpretations so as to continue to gain high spread from structuring and offering bespoke products; and under what conditions and to what extent higher disclosure standards must be met.

Exchange default risk? Some regulators have echoed parallel concerns, for example that expanding the definition of ’standardised’ transactions would put exchanges in the position of clearing illiquid products; and unexpected future systemic shocks might reveal unexpected consequences of such a policy:

  • Centralised clearing is held to reduce counterparty risk, because the exchange is a counterparty to each trade.
  • However, it does not eliminate such risk, because the exchange itself could default on commitments.

This seems unlikely given past history of exchange performance, but is not impossible. Some have suggested that exchanges thus far largely have not defaulted on their commitments because they have limited themselves generally to clearing liquid products.

Congressional priorities The United States has taken the lead in pushing for exchange trading of OTC products, and the US Treasury Department has produced draft legislation. Timely US implementation of meaningful legislation could advance this issue significantly, but any such action is unlikely this year, in part because Congress first will focus on proposals to create a Consumer Financial Protection Agency, and improve regulation of credit ratings agencies.

Outlook. Robust trading activity in OTC derivatives products, including credit derivatives, is likely to continue, and signifies the broader return to ‘normal’ trading conditions. Yet despite the G20 commitment to move more such trading onto organised exchanges, the lack of a strong US lead to move forward quickly to this goal means major changes are unlikely before 2010 — afterward further momentum may dissipate.

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