Since we last published on this subject, the regulatory process has moved on from drawing up technical rules to implementing reforms, allowing us to better assess the consequences for market structure and economic impact.
Some of the more pessimistic views about the impact of new regulations have proved unfounded. For example, the introduction of electronic execution and public trade reporting rules has not so far had an appreciable impact on transaction costs, with bid-ask spreads in major interest rate swap contracts experiencing only a brief spike with the introduction of mandatory SEF trading. Regulators in the US and Europe have been active in engaging with industry to ensure a smooth transition to the new rules. Last year, ESMA delayed mandatory reporting requirements by six weeks in order to meet concerns that many market participants were operationally unprepared. In the US, the CFTC have provided a number of temporary exemptions and no action letters on issues from SEF reporting to inter-affiliate clearing requirements. For their part, dealers have helped to educate clients about the nature of the new rules, as well as investing in new infrastructure and business areas.
Market liquidity is already being fragmented by the new regulations. The earlier implementation of electronic execution requirements in the US has seen a substantial proportion of USD denominated IRS liquidity migrate to SEFs, but this is not so far the case for other currencies, with little evidence of clients in the rest of the world embracing electronic trading. The development of cross- border recognition of clearing regimes will also be crucial. If US and European regulators are unable to agree mutual recognition of each other’s CCPs, this could result in smaller available pools for clients, with detrimental effects for pricing and market efficiency.
The combined impact of OTC rules and banking regulation also raises the prospect of fragmentation. Real money clients may find variation margin difficult to source, leverage ratio requirements may reduce dealers’ ability to provide liquidity transformation services, or increase the costs of them. By contrast, leveraged investors are already used to posting variation margin and will see little additional liquidity risk from existing arrangements, although costs will rise due to higher initial margin requirements and less capacity for netting under the central clearing regime.
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The evolution of costs under central clearing will be path dependent and contingent on macro and micro variables. On a macro level, collateral demand and capital requirements are of central importance. Collateral demand will itself depend on a number of factors, including the degree of consolidation in the clearing industry, cross-border recognition of clearing houses and even monetary policy. Market adaptation to clearing requirements will also influence collateral demand.
From the micro level the economic costs of clearing will be heavily influenced by client circumstances. As our analysis shows, credit rating, the composition of portfolios and the ability to source liquid collateral will have important implications for decision making. Ultimately, we anticipate that in general clearing will raise margin and transaction costs for clients.
The extent to which higher transaction costs are offset by the benefits of decreased systemic risk will depend on how far clearing is economically incentivized and new risks addressed. On the one hand it will be necessary for regulators to ensure that capital requirements for banks and clearing houses are not set at a level which encourages bilateral trading where that choice exists for clients. On the other, regulators must ensure that clearing houses and clearing members are sufficiently well-capitalized to allow them to survive a default of a clearing member. It is a truism that policy is always made for the last crisis and regulators will have to be alive to the new iterations of financial risk arising from the clearing regime such as, for example, the consequences for financial stability of the default of a clearing house itself.
Turning to the model of trade execution, the transition towards electronic trading has proceeded smoothly, and electronic platforms have so far proved robust. SEF volumes have so far been dominated by USD denominated contracts and a few key existing players, so it remains to be seen whether the market will support the large numbers of SEFs that have so far registered with the CFTC. There has been little evidence of a shift towards standardization; although trading in swap futures and MACs has begun to proliferate, volumes remain very small relative to the size of the overall OTC interest rate market. There still remain large white spaces on the regulatory map. Among other matters, the market will eagerly await clarity on extraterritorial rules from the US and Europe, BSBC capital standards for clearing houses, the continued implementation of CRD IV in European jurisdictions and MiFID technical standards to cite a few. Also, while European and US regulators have been most active in finalizing their regulatory framework, elsewhere in the world regulators have also been implementing reform of OTC markets. In Asia reporting requirements have already come into force in jurisdictions from Japan and Australia, while clearing requirements will come into force in Japan and Singapore this year. We note, however, that for the most part regulators have not released rules on extra-territorial recognition. Cross-border cooperation between regulators will be important to ensuring a fair and efficient OTC derivatives market.
Ultimately we anticipate that reforms will lead to gains in pre and post-trade transparency and diminished counterparty credit risk in rates in FX markets, at the expense of generally higher transaction costs. New regulations may also lower systemic risks, although regulators will have to be alert to new risks presented by central clearing.
Alexander Duering, London,+44 (20) 754 55568, alexander.duering@db,com
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Legal disclaimer: This article is intended to provide background information only. Readers should consult with their legal and compliance advisers as to the potential impact of any regulatory provisions noted in this article upon their respective businesses.
The authors would like to thank Jason Vitale, Anurag Singh, Sanchit Pande, Avi Saxena, Abhipreet Das, Mario Muth and Zara Jamil for their contributions to this report
Deutsche Bank AG/London Page 37
Glossary
ARM – Approved Reporting Mechanism
APA – Approved Publication Arrangement
BCBC – Basel Committee on Banking Supervision
BIS – Bank for International Settlements
CAPM – Capital Asset Pricing Model CCP – Central Clearing Counterparties
CEM – Current Exposure Based Method
CFTC – Commodities Futures Trading Commission
CLOB – Central Limit Order Book
CME – Chicago Mercantile Exchange
CCR – Counterparty Credit Risk
CDS– Credit Default Swap
CRD – Capital Requirements Directive
CRR – Capital Requirements Regulation
CSA – Credit Support Annex
CVA – Credit Valuation Adjustment
DCM – Designated Contract Market
DFA – Dodd Frank Act
DTCC – Depository Trust and Clearing Corporation
DVA – Debit Value Adjustment
DvP – Delivery versus Payment
EMIR – European Markets Infrastructure Regulation
ESMA – European Securities and Markets Authority
FCM – Future Commission Merchant
FRA – Forward Rate Agreement
FVA – Funding Value Adjustment
GFMA – Global Financial Markets Association
HFT – High Frequency Trading
IRS – Interest Rate Swap
IOSCO – International Organization of Securities Commission
ISDA – International Swaps and Derivatives Association
LEI – Legal Entity Identifier
LSOC – Legally Separated Operationally Comingled
MAT – Made Available to Trade
MiFID – Markets in Financial Instruments Directive
MFT – Multi-Lateral Trading Facility
NDF – Non-Deliverable Forward
OTC – Over the Counter
OTF – Organized Trading Facility
PB – Prime Brokerage
PFE – Potential Future Exposure
PFMI – Principals of Financial Market Infrastructure
RFQ – Request for Quote
RWA – Risk Weighted Asset
SDR – Swap Data Repository
SEF – Swap Execution Facility
UPI – Unique Product Identifier
USI – Unique Swap Identifier
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