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US Markets on Course for Sweeping Changes to OTC Derivatives Regulation

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The US government has this week released a set of proposals to reform the regulatory regime governing the OTC derivatives markets. The proposals, which were tabled by Treasury secretary Timothy Geithner, would mandate that all derivatives deemed to be “standardised” are cleared via designated clearing houses and they are aimed at increasing transparency in these traditionally opaque markets.

The derivatives markets have come under heavy critical fire since the advent of the financial crisis as a cause of significant systemic risk. The rationale behind the proposals is that central clearing of these instruments would reduce counterparty risk and financial institutions would be required to set aside additional capital to cover potential defaults. Central clearing houses would also be required to produce reports on the trading volumes for these instruments, as well as more detailed information about individual counterparties to regulators, if requested.

Securities and Exchange Commission chairman Mary Schapiro has also suggested that regulators should use the Financial Industry Regulatory Authority’s (Finra) system for bond price reporting, Trace, as a model for transparency and reporting requirements for OTC derivatives. The Trace system, which has been in operation since 2005, provides access to trading information on corporate bonds to anyone with internet access.

“I think it’s something we’ll look at very closely as a potential model,” said Schapiro earlier this week.

Regardless of Trace’s future role, however, it seems that OTC derivatives regulation is on the cards in a big way. “We need better broader authority, better information, and we need a better commitment of supervisory authorities to enforce those laws,” said Geithner during the release of the proposals.

The proposals have not been well received by all corners of the industry, as many are concerned that the increased oversight will prove to be a burden and drive profitability out of the market. For example, Sifma president and CEO, Timothy Ryan, expressed caution, saying: “It is important that new regulatory measures preserve the usefulness of derivatives as risk management tools for American businesses.”

The Wholesale Market Brokers Association (WMBA) is also critical of the negative perception that OTC markets have garnered as a result of the crisis. The association welcomes the moves to clear credit default swaps (CDS) through a central counterparty (CCP) as well as other financial products that are “suitable or relevant” for clearing, but feels the government’s approach to the market is unduly harsh.

David Clark, chairman of the WMBA, explains: “The WMBA wishes to warn again that forcing OTC products onto exchanges would significantly reduce liquidity in financial markets, resulting in increased risks and costs for end users as their ability to hedge their exposures would be handicapped.”

The association points to the fact that most of the severe losses suffered by banks during the crisis occurred in the structured credit markets and not in the OTC CDS market. The OTC world, in the WMBA’s view, should not be driven out of business. “Whist the objective of making markets more secure is supported by all market participants, and certainly WMBA members, the unintended consequences of poorly thought through policy decisions would have a serious impact on the real economy.,” says Clark.

The association has also expressed concern that policymakers have not acknowledged that making markets more secure can be achieved through the clearing of products, both OTC and exchange traded, through recognised CCPs. “The implication being drawn by some market participants and commentators, is that the only way of achieving regulators’ ambitions is to coerce OTC products onto exchanges,” the association says in a statement.

Clark suggests that US regulators instead look to European markets for guidance: “The WMBA believes that European initiatives indicate a firmer grasp of the essential role of the clearing house, and understanding of the transparency and post trade security inherent in the activities of banks, and WMBA members that use platforms that are MiFID compliant in an already regulated environment.”

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