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Industry Underprepared for OTC Derivatives Trading and Market Regulation

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By Ganesh Iyer, Senior Product Marketing Manager for Network Services, IPC Systems

While recent years have seen much talk of financial reforms, there has remained a distinct lack of clarity around what new regulations will mean for financial institutions. In the trading industry, the regulations that will have the biggest impact are European Market Infrastructure Regulation (EMIR) and Dodd Frank.

These regulations, designed specifically to provide greater transparency and to mitigate risk in the OTC derivatives industry, are well anticipated – but are they well prepared for?

IPC recently conducted a survey among hedge funds, investment banks, broker/dealers, exchanges and other financial institutions asking this question, as well as exploring their perceptions of the impending regulations. The responses revealed that financial institutions are underprepared to meet the requirements these regulations will place on them, even as they plan to increase their trading activity in OTC derivatives.

Trading in OTC derivatives has seen huge growth in recent years. It was unsurprising therefore to see that 94% of firms surveyed are already trading swaps or other OTC derivatives or plan to do so in the next six months. However, just 19% believed the industry as a whole was well prepared to meet the regulations. This is perhaps surprising given that 74% of respondents said they expected their firms’ trading volumes to increase in the next year. The findings reinforce what we have seen in the industry, exposing real concerns that neither individual firms nor the industry as a whole are well prepared for the impending regulations.

The industry has questioned whether the regulations will reduce systemic risk as they are intended to. However, only 29% of respondents believed that the reforms will actually result in reduced risk. More positively, 57% agreed that increased market and transaction transparency will be a major benefit resulting from the new regulations. The increased availability of market data is also recognised as an important benefit of the reforms. Worryingly, 21% of respondents felt that there could be consequences for the future of OTC derivatives trading as a result of what they perceive to be ill-conceived rules that have not taken into consideration all elements of risk.

The introduction of Swap Execution Facilities (SEFs) are a pivotal aspect of the regulations in the US. Dodd Frank defined SEFs 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.”

Connectivity to SEFs will be critical for trading firms, not only with regard to compliance but also to gain competitive advantage and capitalise on new opportunities. Some of the industry appears to recognise this as 39% of respondents said that their firm is connected or planning to connect with 10 SEFs or more, and 23% revealed plans to connect to over 20 SEFs. However, 34% of firms still did not have a plan in place to connect to any SEFs.

Current debate centres on whether the upheaval in the OTC derivatives market will drive traders towards the futures market, using new swap futures contracts which offer easier access to similar exposures and at a lower cost. While 66% of respondents are expecting to see a shift to the futures market, it is important to recognise that swaps were created with a specific purpose in mind. It seems more likely that the two markets will coexist, but with some swaps becoming futurised, although not every swap has an economically equivalent future. Currently swap futures do not have the liquidity or investor confidence to really challenge swaps.

With insufficient visibility into the specifics of impending OTC derivatives regulations, it is perhaps unsurprising that many firms have seemingly delayed their planning to meet the new rules. The industry expected to see the regulations detailed in full at the end of 2012, but with delays and setbacks this is now expected in the first half of 2013. Firms must be ready to act quickly to ensure their businesses, systems and processes meet the new guidelines. However, they must also recognise that connectivity to SEFs and various other execution venues will be critical not only for addressing compliance concerns, but also for gaining competitive advantage and capitalising on new opportunities.

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