January 25, 2013 6:40 pm

The future slowly becomes clearer

For some institutional investors and hedge funds, getting Mitt Romney elected president of the US was the last role of the dice.

For more than three years, all parties of the industry loosely described as market infrastructure – exchanges and other trading venues, banks and clearing houses – have been holding detailed, almost exhaustive discussions with global regulators over how to turn a political pledge to reform the derivatives industry into practicable laws.

As debates have ground on, sometimes delving into industry minutiae, it has become clear that the overhaul would be profound and leave few areas of trading untouched.

A successful campaign for Mr Romney was seen by some as the final chance to usher in gentler political winds that would take the heat out of the reforms. But Barack Obama’s victory, and his promise to reform Wall Street, has ended that hope.

“The process has taken a long time and some clients think it just won’t happen. The US presidential election has shifted that. It’s given it a bit of a push,” says the head of clearing at a large global investment bank.

But the fact that some felt there was a chance to influence legislation more than three years after the process got under way highlights how difficult and profound the journey has been, and how many important issues remain unresolved.

As they surveyed the wreckage of the financial crisis, politicians alighted on the opaque off-exchange derivatives market. Leaders from the G20 agreed in September 2009 that more standardised over-the-counter derivatives contracts should be traded on exchanges or electronic trading platforms and processed through clearing houses. A clearing house stands between two parties in a trade, guaranteeing the deal in the event of a default.

Since then national and supranational regulators have been busy writing their own definitions of final technical rules. Analysts and executives expect more business in derivatives to be traded on-exchange as a result and there has been an international consensus on large swaths of the reforms.

But the issues to be resolved by regulators and the industry are critical. They include what will have to be traded, who qualifies and how far regulatory jurisdiction can reach. As a result it is slowing down the passing of legislation and the codification of laws, and leaving banks and investors unable to make decisions.

Relevant legislation in the US and Europe, in the form of the Dodd-Frank act and the European Market Infrastructure Regulation respectively, is on its way. But the difficulties contributed to virtually every regulatory authority missing the G20-imposed deadline for the end of 2012. Indeed, Dodd-Frank passed into law more than two years ago.

Some certainties are emerging. For many fund managers, pension managers and other institutional investors, the move is a radical departure from previous practice. Part of the attraction of the OTC market had been that participants needed little, if any collateral or insurance for trading, for their deals. These reforms are creating greater choice over which markets and clearing houses to go to, and ways to execute trades, when using derivatives to offset risks in a portfolio.

The more illiquid OTC market provides investors with bespoke products such as swaps, forward rate agreements and exotic options. By contrast, exchange-traded futures and options are more standardised products. Contracts are smaller but far more liquid.

But greater freedom also brings greater responsibility. The corollary is that many institutional investors need a fuller understanding of clearing and cannot rely on their broker to make decisions, even if that broker can collect margin and connect to the right venue on their behalf.

“One of the more frequent questions we get from clients is about where to clear. The answer is that we’ll go where customers want us to go,” says Andrew Ross, European head of OTC clearing at Morgan Stanley. “We don’t believe it’s the bank’s role to tell clients where to clear their trades.”

It is also clear that institutional investors will face higher costs for trading. Using an exchange or other electronic venue requires investors to put up collateral against the deal. However, the G20 communiqué also made explicit that contracts not processed through clearing houses be subject to higher capital requirements.

“Our members aren’t against clearing; they have concerns such as how much collateral they have to put up and worries that it might be double counted,” says Dan Waters, managing director of ICI Global, a trade association for global fund managers.

These are not idle fears. Research from fund managers has indicated the margin required to be put up could be as much as 10-20 per cent of a portfolio. But as the final rules have not been decided, nobody can put a precise figure on the impact. In Europe, for example, pension funds have been given a temporary exemption for clearing in Emir, but the final details for capital charges on non-cleared derivatives are still to be decided.

“Placing strict requirements on the type of assets that can be used as collateral for derivatives positions will make it challenging for some fund managers to invest in those products,” warns Marianne Brown, chief executive of Omgeo, a post-trade services company. “If a particular firm does not have sufficient eligible collateral on hand, they may need to perform collateral transformation which can be complex and could add operational risk,” she adds.

Amid these concerns, some have considered moving more business to Asia and growing financial centres such as Hong Kong and Singapore. Reform efforts are also generally further behind the US and Europe, although Japan has already mandated central clearing of yen interest rate swaps via its domestic banks.

But even here complications arise. Along with their counterparts in the EU, many regulators in the region have voiced their unhappiness with US proposals that could increase the compliance burden on local investors. Measures suggested by the Commodity Futures Trading Commission, the US derivatives regulator, that may force overseas investors to accept tougher and expensive US laws have prompted rare public criticism from authorities in Japan, Australia, Singapore and Hong Kong.

However, regulators are exploring ways to recognise each other’s jurisdiction, rather than reject it outright. Furthermore, many markets in the region have little OTC derivatives business and are in the process of building the infrastructure. While the US and Europe developed institutions independent of an exchange, in places such as Hong Kong it is the local bourse that is at the forefront of developments.

These same exchanges are looking to western counterparts for their models. Hong Kong Exchanges and Clearing, Asia’s largest exchange, is to begin OTC clearing from April and is looking to attract key broker-dealer customers as it builds its credit default swaps business. The approach of selling part of a chunk of the clearing house to users consciously borrowed from a model used by IntercontinentalExchange (ICE).

Lee McCormack, client clearing business development manager at Nomura, the Japanese securities house, says finalising the rules in Europe might give Asia a push to finish its own legislation.

“I don’t think any banks will want to be seen helping clients avoid Emir or Dodd-Frank,” he says. “Liquidity provision to Asian clients from European and US dealers could be impacted if they do not participate in OTC clearing, for example.”

Amid such tumultuous changes, few are willing to make long-term predictions on the future of the OTC market. Indeed, one potential new area of business is emerging in the US, which is closer to a final codification of its laws. In recent months, ICE and CME Group have begun touting hybrid products that have the economic profile of an interest rate swap but trade like a standardised future – a development known as the “futurisation” of swaps.

The complexity of the industry may only increase.

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