Following the publication of its white paper on an overhaul of the OTC derivatives regulatory regime last month, the US government has finally sent its proposals to Congress, which will vote on them once it returns from its August recess. The proposals include requirements for the more vanilla end of the spectrum of these instruments to be executed on exchanges and centrally cleared.
In addition to the government’s white paper, the House Financial Services Committee, which is chaired by Barney Frank, and the House Agriculture Committee, chaired by Collin Peterson, released a concept paper that is likely to act as the basis for the future regulation. The concept paper largely backs up the government proposals but adds a few more details in certain areas, such as more restrictions on the use of credit default swaps (CDSs) and reporting requirements for these instruments.
The proposals have been broadly accepted by the market thus far as a means of increasing transparency and trust within the derivatives space. Financial institutions will also need to be more risk aware of their holdings in these products and will therefore be subject to additional capital holding requirements. There is some concern that new capital charges for customised derivative products may drive some of the business out of this market. Others have criticised the government for not going far enough to regulate these more exotic products and for allowing the possibility of further abuses of the system.
The new rules will also likely spark a period of innovation in the market with the establishment of a new network of clearing central counterparties (CCPs) beyond those already in place for CDS clearing.
Electronic trading venues have also been pleased by the government’s proposals and earlier this week Tradeweb pitched its own platform, which was launched in 2005, as a contender for some of this flow. “The message from Treasury is clear. It is looking for a more streamlined and transparent derivatives industry. Electronic trading clearly answers these concerns and Tradeweb looks forward to playing a major role in helping the market adopt these important measures,” says Lee Olesky, CEO of Tradeweb. “In addition, we welcome the opportunity to link to, and partner with, clearing houses to ensure that the overall marketplace operates efficiently.”
The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have been charged with jointly policing the sector, although this may prove problematic in future given their history of turf wars. The regulators will be empowered to prevent attempts by market participants to pass standardised derivatives off as customised derivatives in order to avoid central execution and clearing.
Gary Gensler, the CFTC chairman, has estimated that the more standardised end of the market is around 80% of the OTC derivatives being traded today. The CFTC has also recently held a series of three hearings on the subject of position limits for speculators in the energy markets and this is likely to be a subject of further discussion and the publication of a draft rule in September.
Senator Charles Schumer is also working on drawing up legislation to require firms to provide consolidated reporting of these OTC derivatives trades to a new central warehouse. The theory behind this is to allow regulators access to a consolidated store of data on the market for the purposes of greater transparency.
The Depository Trust & Clearing Corporation (DTCC) is pitching itself as the main contender to be the facilitator of storing this data. Donald Donahue, chairman and CEO of the DTCC has been campaigning over the last few months for its Trade Information Warehouse to be selected as the repository of this data. Rather than multiple repositories, Donahue says a consolidated approach is required.
“We believe that having all of this information residing in a single place is a crucial contribution to reducing risk and promoting market efficiency. When markets are in turmoil, it is critical that regulators have the ability to see the full details on the underlying trading positions of derivatives contracts from a central vantage point to quickly assess systemic risk across the financial system – and to bring greater transparency to the market. This snapshot of the market can only be provided by a single global repository,” he says.
Accordingly, the DTCC has filed for limited trust status for the Warehouse to become a wholly owned subsidiary of DTCC DerivServ. “In filing this application to create the Warehouse Trust Company, DTCC is responding to the expressed intentions from regulators globally to bring added risk protection and regulatory oversight to the credit derivatives market,” explains Donahue.
Turning back to the bigger picture, what these proposals all essentially mean for those players in the derivatives trading and clearing space, such as Tradeweb or IntercontinentalExchange (ICE), is that Christmas has come early. Firms will be compelled to move their trades onto these platforms and thus will boost current flows considerably.
For financial institutions it will mean a greater need to track derivatives data in order to meet reporting requirements and the impetus to introduce greater levels of standardisation and automation in the back office. By putting these instruments onto electronic execution and clearing venues, latency will become more of a differentiating factor within the market. This, of course, means that those vendors sitting in the data and risk category will also likely see an uptick in investment. Roll on September…