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The $650 trillion question: Navigating the OTC market maze in a new regulatory era

Published in Automated Trader Magazine Issue 26 Q3 2012

Miffed about MiFID II? Think Dodd-Frank should be more appropriately named Dead-Frank? Whatever side of the Great Regulatory Debate you're on, the next few months are likely to go down as one of the more crucial periods in modern financial history for OTC markets. Adam Cox and Tarryn Riley spoke to a host of players to get the low-down.

sign postNearly two years after the Dodd-Frank act was passed, those calling for tighter shackles on Wall Street were handed a gift: the venerable J.P. Morgan had just disclosed spectacular losses from a complex trade gone awry.

Many industry observers said the losses, while tiny compared with what happened to the industry in late 2008, would serve to stiffen the resolve of regulators in the face of loud and vociferous complaints from the industry. What's more, the timing could not have been more critical, with the news coming just as a wave of new rules for over-the-counter markets was about to come crashing down on both sides of the Atlantic.

Others could argue that the regulatory campaign was so far along that the window for adjustments or delays to implementation had already closed. Either way, no one was disputing whether the trading mishap had intensified debate on the wisdom of regulation for a market as large, diverse and complex as the $650 trillion OTC market.

First put at $2 billion but expected to end up being sharply higher, the J.P. Morgan losses came just as regulators were struggling to work out how to implement parts of Dodd-Frank. Events such as these, after all, were just what inspired the sweeping law, the centrepiece of U.S. President Barack Obama's financial reform efforts.

Obama himself was not shy about weighing in. "J.P. Morgan is one of the best-managed banks there is," the president said during a television interview not long after news of the losses. "Jamie Dimon, the head of it, is one of the smartest bankers we got, and they still lost $2 billion and counting."

So what can the industry expect during the coming months as the US and European regulators put the finishing touches on scores of new rules that have far-reaching implications? The answer depends very much on whom you speak to and what positions they have in what has become a very high-stakes game of regulatory roulette.

Questions about terminology, definitions, jurisdiction, coordination and the scope of surveillance all loom large. The size and idiosyncratic nature of the market is another factor. At the same time, mindsets have been calcifying in both the financial and regulatory communities.

Global OTC Derivatives

Global OTC Derivatives
By data type and market risk category, in trillions of US dollars

"Underneath all of these things," said Richard Baker, chief executive of Singapore-based OTC exchange Cleartrade, "is a whole host of political and emotional issues."

Baker said some of that is linked to the way in which officials around the world have not been very coordinated since they started the campaign in 2008 for a regulatory overhaul.

"And we have had the cry wolf from the regulator too many times now. We've had false dates set for swap definition, for swap dealer definition, for SEF registration. Really we've had an industry in limbo almost for a couple of years."

Worse still, being in limbo has not necessarily meant standing still. Baker said limbo could mean making investments and trying to change how business is done - for instance trying to build a trade repository or getting ready to clear and report in a certain way - only to find that the rules failed to appear or that they shifted.

Richard Baker

Richard Baker

Regulating at breakneck speed

According to the script that US and European regulators are following, all of that is about to change. Scott O'Malia, one of five commissioners at the Commodity Futures Trading Commission, outlined at the end of May a reform agenda that was little short of breath-taking.

The CFTC's long-awaited definition of a swap would be issued in the weeks ahead, as would cross-border guidance, mandatory clearing determinations and the final implementation timetable for clearing. All of that plus a vote on rules regarding trade execution, including the final rules for SEFs, as well as something called Core Principle 9 for Designated Contract Markets.

If nothing else, it would all lift the uncertainty. On the downside, working at this pace meant there could be mistakes. O'Malia, who has been outspoken in his criticism of the pace of reform, said as much in an industry speech. "The pace has been frenetic. We have not spent enough time thinking through all of the potential issues," he said.

The clock started ticking in 2009, in Pittsburgh, when the G20 declared: "All standardised OTC derivative contracts should be traded on exchanges or electronic platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest."

To put that in context, it's worth considering the size of the OTC market.

Total market value of all OTC derivatives contracts in countries reporting data to the Bank for International Settlements, as of the end of 2011, was $27 trillion, the second highest amount on record and only eclipsed by a pre-crisis peak well above $30 trillion in 2008. As large as those numbers sound, they're dwarfed by the notional value of all OTC derivatives contracts. That figure stood at nearly $650 trillion at the end of last year.

The so-called G20 mandate helped bring about the passage of Dodd-Frank in the United States and the European Market Infrastructure Regulation, or EMIR, in Europe. Under EMIR, the European Securities Market Authority (ESMA) is due to introduce technical standards for OTC contracts. Both EMIR and Dodd-Frank share the goal of wanting to make the enormous OTC market as transparent as possible.

Some groups such as Cleartrade have been able to design their platforms with new regulation in mind.

"We were an early adopter and we used this regulatory reform as a catalyst for change," Baker said.

All of that actually is a key driver to our business plan and the operational architecture we've put in for the business as well as the technical investment we've been making."

Christian Martin

Christian Martin

Baker added, "Price transparency is ultimately all participants in the market should be able to see the prices on offer - even if they're telephone-broked, they should be disclosed to the market before they form a trade. We really built Cleartrade in a technology capacity to intercept a lot of that regulation."

The chief executive of EuroCCP, Diana Chan, said new rules may mean new investments but they could mean new opportunity. Few sectors of the industry are as directly affected by the drive for clearing of OTC markets as central counterparty clearinghouses (CCPs).

Speaking of ESMA's new technical standards, Chan said: "It is probably safe to say that all CCPs
will need to make some changes to how they operate today, whether they clear OTC or exchange-traded derivatives. Some may need to invest in more changes than others."

But she added: "The regulatory environment is taking shape and derivatives CCPs who can position themselves to take advantage of opportunities early will have the first mover advantage, which is critical in a network industry, particularly as interoperability is not envisaged for a few years".

Cleartrade, which allows for trading of contracts on commodities such as iron ore, in a sense has come of age at the exact same time as the regulatory reform movement. It was built in 2009 and launched as a business in 2010 before trading began in June 2011. That could be one reason it has been in a position to make its business model so reform-friendly. For instance,as the exchange was just getting going, it engaged in a deep dialogue with its regulator, the Monetary Authority of Singapore.

Baker, unlike many market participants, views the push for transparency as an appropriate response on the part of officials and he said the exchange is all geared up for the reporting requirements that are called for. But he acknowledges that others, such as CCPs, may feel differently.

"I think that it's fair to say it is a concern for the CCPs today. And many are investing and/or objecting to this process. However, again unfortunately through the last three major banking events that we've had, it's kind of warranted that this change needs to happen because there is not the rigour throughout the food chain or the value chain of keeping full segregation and full reporting."

Christian Martin, chief executive of swaps exchange facility TeraExchange, said the perceived challenges to market participants, particularly the sell-side, may be overstated.

Noting that futures and options have historically been traded on exchanges, the question of regulating OTC markets is a matter of taking what is known and "applying it to a different asset class".

But speak to a variety of market participants and it becomes clear that comments such as these are more the exception than the rule. At a swaps and derivatives conference in London in May, a number of panel sessions and addresses focused on regulation and the bulk of the comments from speakers were critical.

For instance Daniel Marcus, global head of strategy at inter-dealer broker Tradition, lamented the cost of collateral that would be incurred as a result of the new rules. "Taking collateral away, and the ability to use it as genuine liquidity to trade, can reduce liquidity in the market, potentially causing a liquidity crisis. Now that is something that clearly the market doesn't want," Marcus told the conference.

The issue of increased demands for collateral came sharply into focus last year when a senior economist with the IMF forecast the planned shift of standardised OTC derivatives trades to CCP clearing from end-2012 could expose a collateral shortage of $2 trillion.

Another group that is not necessarily greeting the onslaught of rules with open arms: the myriad small trading firms that have sprouted up in recent years as technology and a host of new trading venues have allowed high-tech buy-side players to set up shop. Depending on the categories they find themselves in, they may face extra reporting requirements and that means new demands on their IT systems. For a large or mid-size firm that has an IT department, this may not be as big a deal. But for a company of half a dozen people, the costs from investment can far outweigh the benefits, even if a new architecture results in lower cost-per-trade.

Diana Chan

Diana Chan

Bid/offer quotes from a Bermuda beach

Still, those who find their blood pressure rising at the very word regulation can take heart. One industry expert believes that many of the rules being written are doomed to failure - at least when it comes to OTC trading.

"These are really just bilateral contracts between two parties to do something," said Peter Vinella, a former banker turned consultant who has worked with the U.S. government and testified before Congress on various occasions over the years,

"If they came up to me tomorrow and said, 'You're not allowed to do an asset swap, ever again, I'll come up with something called the 'Bob Contract'. It'll do exactly what an asset swap does, but it'll have a different name," he said. "I don't have to call it a CDS. I don't have to have it governed by an ISDA agreement."

Vinella, who directs Berkeley Research Group in Berkeley, California, said this is exactly what frustrated him when dealing with Congress.

"I'd go there and I'd say 'Okay, what jurisdiction are you going to put this under? You know, you don't want me to do it here, I'll do it in Bermuda. If Bermuda won't let me do it, I'll do it in Brazil. If Brazil won't let me do it, I'll do it in Chad.' I mean, somewhere I'm going to find some jurisdiction that's going to let me write the contract."

Cleartrade's Baker reckons that the scope for escaping a jurisdiction has been greatly reduced.

"I've been party to two or three regulatory meetings in the last 12 months, where we've seen the kind of G20 regulatory bodies meeting and getting themselves aligned on these objectives," he said.

Baker noted that in Singapore, MAS, had left no doubt it meant business.

"There was a very clear message coming out of Singapore, that is: 'We're not open for arbitrage. We will be party to this global remedy'. We're seeing the same out of Hong Kong. We're certainly seeing the same here in Europe. So I think for the major G20 states, I don't see the opportunity for moving geographically and avoiding what's being implemented."

Regardless, Vinella thinks there is plenty in Dodd-Frank that may not turn out to be practical.

"When you look at Dodd-Frank, first of all I think the Volcker Rule is impractical, I don't know that you'd go backwards in time," Vinella said, referring to the rule designed to prevent proprietary trading by banks. The measure, which to some extent seeks to replicate the environment under the old Glass-Steagall legislation in the United States, ultimately was loosened to allow banks to invest in hedge funds.

Peter Vinella

Peter Vinella

"The reason Glass-Steagall was repealed was because it was effectively repealed anyway. Banks had figured out how to get around it, and again, because the jurisdiction in the United States is relatively finite, you can do things offshore."

The idea of a derivatives clearing house also strikes Vinella as problematic. On top of all that, he said the regulatory players in the United States are forever fighting turf wars instead of working together, creating a toxic mix for getting anything done.

"I kind of look at it like the pitchfork-and-torches peasant reaction in Frankenstein. Everyone gets up and says 'Yeah, yeah, let's do it'. It sounds good when you're talking to them, but I don't think that it's practical."

The consultant says the one-sided approach where government puts its foot down simply doesn't work. "If you leave it to a politician to come up with the regulation around a bank, it's going to be bad. I agree with the banks on that, because they just don't know the banks well enough to know how to impose a regulation."

Ironically, Vinella said one person who could end up fostering the necessary dialogue to start fixing the problems is J.P. Morgan's Dimon himself.

"That's the kind of thing he could do. He could sit there and say, 'I'm going to use this $2 billion loss as a call to all the other bankers. Let's get together, let's propose a realistic regulatory framework, we'll work with the regulators, and let's get rid of all the other bullshit that we do', as opposed to creating all these committees and lobby organisations that just basically say no to everything."

As an aside, Vinella noted that he had once been a report of Dimon's. "I think he's one of the greatest guys I've ever met. I'd work for him in a second," he said. "He's smart, he knows what he's doing"

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