Regulatory Uncertainty Hovers over OTC Markets

Terry Flanagan

Uncertainty surrounding regulations and a decline in OTC derivatives notionally is causing market participants to reexamine the landscape to understand how they are being affected by recent and upcoming changes.

“Regulatory uncertainty has plagued us since the financial crisis (and how the markets hate uncertainty) and we are now only seeing glimpses of the first deadlines coming through,” said Bob Park, CEO of Fincad, a provider of risk analytics. “But what cases, if any, can we look to as examples of positive derivatives regulations, and what should be avoided?”
Dodd-Frank, “banging the drum of transparency, is an example of regulations that are so ambitious, you almost have to wonder if it was set up to fail.”

Despite the time it’s taken and numerous consultations, Dodd-Frank’s requirement for exchange traded and centrally cleared derivatives has resulted in a chorus of disapproval from large U.S. and international banks which fear that full transparency into pricing will lower derivatives spreads and consequently reduce profit margins.

“The regulation’s extra-territoriality rules are also raising criticism worldwide from banks who do not want to be held accountable to U.S. regulations in addition to their regional ones,” Park said.

They are pushing instead for a substituted compliance approach, where banks are only accountable to their local jurisdictions, as long as those regulations are similar to Dodd-Frank.

“While theoretically viable, this could be another delay tactic to avoid regulatory requirements in countries that have less stringent requirements than the U.S.,” Park said.

International rules governing margin requirements for OTC derivatives and the resolution of issues related to the cross-border application of derivatives rules are two of the most important matters facing global regulators and the industry.
“A clean, efficient and fair cross-border framework and an appropriate margin regime, centered around robust variation margin, are essential components of the regulatory reform mosaic,” said Stephen O’Connor, chairman of the International Swaps and Derivatives Association, in a statement. “The outcome of policymakers’ decisions for these critical issues will have tremendous implications for global markets and for many thousands of OTC derivatives end-users in the real economy around the world.”

The U.S. Department of Treasury’s recent exemption of foreign exchange swaps and forward contracts from Dodd-Frank regulation hints to possible further compromises with regulatory oversight containing potential loopholes and concessions, said Park.

Brazil, a relative newcomer to the derivatives marketplace, is perhaps a model example of an ideal derivatives marketplace.

“This emerging market is uniquely positioned, as since its inception, almost all of its derivatives are either exchange traded or centrally cleared through BM&FBovespa and Cetip, respectively,” said Park.

Originally almost entirely comprised of commodity derivatives, foreign exchange and interest rate futures now make up the majority of all contacts. All trades, including OTC (20% of all traded derivatives in Brazil), must be registered with an authority.

Brazil also has advanced middle and back office processes in place, allowing same day settlement of all trades.
“All these combine to give Brazil a very open, transparent derivatives market with a high degree of regulatory oversight,” Park said. “However, no system is perfect, and strict tax laws, limits to the range of products available, and potentially rising costs are all areas of concern for Brazil’s derivatives market.”

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