Staying One Step Ahead Of Derivatives Regulation

Terry Flanagan

With market participants still unsure as to how the reforms sweeping across the U.S. and European derivatives markets will play out, firms are being urged to second guess the regulators in a bid to stay one step ahead of the pack.

The mandate from the G20 group of nations is likely to result in the formation of new venues for trading over-the-counter derivatives on electronic platforms. The new rules, once finalized, are slated in to take effect from the beginning of next year across the globe.

“Just as we saw with MiFID [in 2007] and in the equities world, a lot of people obsessed about checklists and operational readiness—I am not saying that is not hugely important—but there is a bigger issue,” Steve Grob, director of group strategy at Fidessa, a trading and technology company, told Markets Media at the annual FIA/FOA International Derivatives Expo conference in London this week.

“You have to be able to try and make predictions about what the landscape is going to be and make some bets on what shape your business is going to have to be in the future and if you wait for all the mist to clear it is going to be too late. That’s the challenge.”

In the U.S. derivatives space, the Dodd-Frank Act has proposed the establishment of a swap execution facility (SEF), which the Securities and Exchange Commission broadly defines as “a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce”.

Meanwhile, in Europe a new trading venue called an organized trading facility (OTF) has been put forward by the European Commission as part of its MiFID II reforms which is intended to be similar in scope to a SEF.

The goal of SEFs and OTFs is to bring transparency and structure to OTC derivatives trading. While the definitions of SEFs and OTFs may appear similar, there are some differences in their structure in the current writing of the regulations. OTFs, for example, are much broader in scope and are designed not just for the trading of swaps but of equities, commodities and other derivative contracts. OTFs also allow discretion over how trades are executed, leaving room for voice brokerage of deals as well as electronic trading.

But given the global nature of OTC derivatives markets, closer cross-border co-ordination of regulatory and supervisory frameworks is likely to be required to avoid regulatory arbitrage.

“Firms are wondering: should I be a SEF or should I be this or that?” said Grob. “And that’s one thing we are spending a lot of time sitting down with our customers, saying ‘let’s get together and make some bets on how we think things are going to go and then you can start to think about your workflow and what technology you need to support it’.

“It isn’t about taking your existing business and doing this and that and the other. Everyone has to do that, but if you are only doing that you are missing the point.

“If you just see regulation as a compliance issue, then you are going to run out of money. Unless you can turn it to your advantage, you are going to struggle. In the equities world, the OTC and exchange-traded market has existed as one since equities were first traded whereas up to now the OTC and exchange-traded derivatives world has gone on parallel but very separate paths—but now they are coming to a crossroads and no-one knows whether it’s going to be a train wreck or not.

“So you have to look and understand the regulation as it is and make some predictions on the basis of how you think the market will shape up. For example, with SEFs and OTFs there is a first mover disadvantage—people are saying I don’t want to go first because if there are 40 of these things in a year, there will likely only be five or 10 a year later. So maybe the smart play is to be the aggregation piece sitting in front of all this, facing off to the buy side.”

The reforms are all part of the push by the G20 to better regulate the opaque $700 trillion OTC derivatives sector, which accounts for roughly 95% of all derivatives trades by volume. The previously unregulated sector has been blamed, in some quarters, for the global financial crisis and the collapse of Lehman Brothers in 2008.

One seismic shift that will be a result of the reforms will be that most OTC derivatives trades will be pushed through centralized clearing from the start of next year, in a diktat from the G20, to reduce systemic risk.

“There will be the Big Bang event that will force everything to clearing but then, over time, we are going to see the markets evolve, stocks mature and a lot of things shake down over the next few years,” Alun Green, general manager of SunGard’s Stream GMI division, which provides derivatives clearing software solutions, told Markets Media.

“Most customers have now made their decisions on their technology for OTC clearing. There has been a lot of preparatory work but the regulations have still yet to kick in and there are still areas of uncertainty in the market as rule-making has not been finalized on both sides of the Atlantic.”

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