International trading needs global oversight

It was an arresting moment of candour.

In a speech in September, William Dudley, president of the Federal Reserve Bank of New York, was clearer than many officials have been about whether regulators and market participants are going to meet deadlines for implementing sweeping reform of over-the-counter derivatives markets.

“It is unlikely that the G20 countries will meet the goal to clear all standardised over-the-counter derivative trades through central clearing counterparties by the end of 2012,” he told the international council meeting in Washington of the Bretton Woods Committee, which is dedicated to increasing understanding of multilateral financial institutions.

His warning highlights a growing concern for banks, brokers, exchanges, clearing houses and “buy-side” users of OTC derivatives such as asset managers and hedge funds.

At the G20 meeting in Pittsburgh in 2009, regulators agreed to a comprehensive clean-up of the financial system in the wake of the collapse of Lehman Brothers, the US bank. That called for the bulk of OTC derivatives markets to be brought on to formal trading platforms and for standardised derivatives contracts that are eligible for processing through clearing houses to be cleared.

The aim was to shift most OTC derivatives trading into a more transparent environment where prices could be seen by a wide range of market participants – and away from the bilaterally negotiated market hitherto controlled by Wall Street banks. It was hoped that the safeguards that clearing offers would help reduce the impact on the financial system in case of a big default.

Progress has been made by US and European regulators on implementing the new rules, enshrined in the Dodd-Frank Act in the US and the European Market Infrastructure Regulation (Emir) and Markets in Financial Instruments Directive (Mifid) in Europe.

But, as Mr Dudley warned, cracks have started to appear between the US and Europe on key issues, what he referred to as a “cross-border coordination problem”.

“Regulatory oversight is national, but many financial firms and infrastructures operate on a global basis. Effective reform requires mutually consistent global standards, and while international co-operation to date has been good on many fronts, progress is uneven,” he said.

On clearing, there are concerns that too many clearing initiatives are emerging that could fragment liquidity in the OTC derivatives markets. That would make it harder for regulators to monitor and oversee risk, since the activity would be taking place through multiple clearing houses.

Yet countries such as Canada and Australia are thinking about building their own OTC clearing infrastructure.

In September, Timothy Lane, deputy governor of the Bank of Canada, said that country was also considering devising its own OTC clearing capability because of reliance on the few large clearing houses, or central counterparties (CCPs), that already exist in the US and Europe, and which are dominated by global dealers that had “considerable entrenched advantages in settlement costs”.

Building a domestic CCP would make it “more straightforward” for Canadian authorities to oversee such a systemically important institution, he said, and to provide emergency financial support for it in a crisis.

Yet Josh Sutton, vice-president at Sapient Global Markets, a technology consultancy, says: “This proliferation of CCPs is likely to create challenges. Without a greater degree of harmonisation the regional trade associations fear that trading derivatives may become prohibitively expensive and lead to complex, counterproductive trade scenarios.”

On derivatives trading, it is not a proliferation of platforms that is a concern. It is a divergence in proposed rules for how such platforms are to be defined that worries many.

In the US, Dodd-Frank stipulates the creation of swap execution facilities (SEFs), a new type of platform — likely to be electronic — on which OTC derivatives are to be traded as far as possible. In Europe, Mifid proposes that OTC derivatives be traded on an existing category of platform known as a multilateral trading facility, or a new one called an organised trading facility (OTF).

The Commodity Futures Trading Commission, the US futures regulator charged with fleshing out key definitions of Dodd-Frank, has yet to decide what form an SEF should take. But Gary Gensler, CFTC chairman, has said he believes SEFs should be built in a way that allows prices to be seen by a wide variety of market participants – fairly close to the model of an exchange.

He is keen to move the OTC derivatives market away from dealer control to one where “investors, hedgers and speculators …meet in an open and competitive central market”.

Yet Europe’s OTF model is more flexible in accommodating the existing dealer model, raising the prospect of a gulf between the US and Europe that could cause business to leave the US.

Arthur Hahn, chairman of the national financial services practice at Katten Muchin Rosenman, the law firm, says: “The US has fairly rigorous requirements for how trading takes place on an SEF. In Europe, a voice-brokered or a dealer-dominated model may emerge. I think Europe can justify a different model yet still comply with G20. That may be a major chance for business and regulatory arbitrage.”