March 10, 2013 4:33 pm

US and Europe launch derivatives reform

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The drive to overhaul the derivatives markets in the wake of the financial crisis will take a significant step forward in the US and Europe this week when new rules start protecting investors from defaults.

Large users of swaps in the US, such as banks, will be required from Monday to process trades through clearing houses as the industry is forced to comply with a mandate agreed by the G20 more than three years ago.

Many of those same clearing houses will be able to apply to run similar operations in Europe from Thursday under the new rules, which regulators expect will be in place on the continent in over a year’s time.

“This is the starting point of a new era for the derivatives industry,” said Will Rhode, analyst at Tabb Group.

However the sweeping overhaul has provoked deep controversy between regulators, banks and exchanges over the future of derivatives trading.

The globalisation of financial markets in recent decades has led to a boom in the use of derivatives as corporations and banks look to protect themselves against sudden changes in interest rates and bonds.

Global authorities have focused on the opacity and counterparty risk in the vast, bank-dominated $640tn over-the-counter market – issues that dramatically emerged with the bankruptcy of Lehman Brothers and the near failure of AIG in 2008.

Regulators are pushing for more trades to move on to electronic trading venues and be processed through clearing houses, which guarantee trades between two parties if one defaults.

However, exchanges have seen the overhaul as a commercial opportunity.

Many own clearing houses and are pushing standardised, listed products that share many economic properties of a swap but cost less to trade.

“It is possible that the swaps markets will go through a structural transformation, where there would be a consolidation of business activity around more liquid swaps, while swaps with certain characteristics that are currently not being offered would also be available to market participants,” said Andrei Kirilenko, professor at the MIT Sloan School of Management, and former chief economist for the Commodity Futures Trading Commission, the industry’s main regulator.

The debate is likely to take centre stage at the industry’s annual conference held by the Futures Industry Association in Florida this week.

There has already been a sharp burst of activity in the run-up to the deadline as so-called category one users, who transact more than 200 derivative trades a month, have already started clearing their positions ahead of Monday’s starting date.

LCH.Clearnet, which clears the vast majority of swaps executed by dealers, has cleared nearly $24tn in notional value of interest rate swaps from virtually nothing a year ago.

“We anticipate there may be some teething issues with technology as systems are connected to additional accounts and clear greater volume,” said Ray Kahn, head of OTC clearing at Barclays, which has cleared upwards of $13tn in client trades through the main clearing houses, LCH, IntercontinentalExchange and CME Group.

Europe is further behind the implementation process but on Thursday key technical standards come into force that will allow clearing houses planning to operate in the European Union a six-month window to apply for authorisation. While clearing houses in Europe already clear derivatives, they do so under an older system of rules.

Additional reporting by Gregory Meyer

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