Industry Still Not Ready For OTC Derivatives Reforms

Terry Flanagan

Financial institutions are being warned that they are still woefully underprepared to handle the new regulations that will govern over-the-counter derivatives trading.

Two new studies this week highlight the problems that firms are facing as new regulations that are currently being introduced to shine more light into the opaque world of OTC derivatives in a bid to reduce systemic risk following the financial crisis come into view.

In the U.S., the Dodd-Frank Act is mandating the trading of swaps on to a new type of trading platform called a swap execution facility (SEF), while in Europe similar rules, in the form of Emir, will require all standardized OTC derivatives products to be cleared centrally and reported to a trade repository.

The first study, which was conducted by trading communications provider IPC Systems and generated responses from hedge funds, investment banks, broker-dealers and exchanges, found that 36% of these firms did not have any plan in place at all to deal with the new regulations and 62% were only slightly prepared.

Interestingly, two-thirds of the respondents expected to see a trading shift to futures markets, while the fragmented nature of the expected new derivatives landscape was also evident with 39% of respondents saying that they plan to connect to more than 10 SEFs and 23% saying that they will connect to more than 20.

“OTC derivatives trading has been hotly debated for the last few years, yet there is concern—and in some cases an outright admission—that neither individual firms nor the industry as a whole are well-prepared for the coming changes,” said Ganesh Iyer, senior product marketing manager, at IPC.

“This concern is juxtaposed against an already operating and fast-growing market. Taken together, these points underscore what we have concluded and what our customers have learned: connectivity to SEFs and the various other OTC derivatives execution venues is critical not only for addressing compliance concerns but also for gaining competitive advantage and capitalizing on new opportunities.”

The second report, by Woodbine Associates, a capital markets consultancy, analyzed the business, operational and technology requirements required by firms to be ready for Dodd-Frank and Emir.

“Buy-side firms and derivative end users need to move full speed ahead to ensure they can trade swaps effectively in the new market structure,” said Sean Owens, director of fixed income and derivatives at Woodbine Associates, and author of the report.

“The derivative markets are in the process of undergoing a substantial transformation. Firms must meet both baseline regulatory requirements and a broader set of business needs for optimal performance. Management must ensure they have the capabilities and flexibility to meet the challenges of the evolving environment. Immediate action is essential.”

The report found that firms will need enhanced capabilities to process, finance and allocate collateral to minimize the costs associated with restrictive central counterparty (CCP) and counterparty margin requirements. The selection of a CCP and futures commission merchant will also therefore substantially impact on the future capability and flexibility of a firm, the study found.

The study also identified pre-trade analysis as another area the buy side need to invest in to lower costs, while internal compliance, position monitoring and risk management responsibilities will significantly increase for end users under the new rules.

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