Securities Services
Derivatives: Still struggling with some fundamental issues
There is still considerable uncertainty despite the move towards central clearing of OTC trades. As guest blogger, John Gubert, discovered at the Sibos conference in Toronto, there are fears the G20 timetable is too rushed and opposition to mandatory use of CCPs.
There have been so many political attacks on anyone who includes the word “derivative” in their title or their CV, primarily from politicians devoid of real knowledge of the sector, that SWIFT were brave to facilitate a session that would defend their role. Or, perhaps, being in Canada, a country that avoided most of the financial pitfalls of their southern and western neighbours, they felt more secure than if they had been in Frankfurt, Strasbourg, Brussels or even New York.
But institutions hedging (and thus reducing risk) will carry extra costs as their hedging instruments bring about a need for initial margin (which they currently do not pay on bilateral contracts) as well as variation margin requiring CCP-dictated collateral rather than assets drawn from their investment portfolio. And the panel of experts posed a sound question to be asked on the actual riskiness of some of the illiquid derivative contracts, especially those where there are no plans to redeem before maturity.
Another interesting point was made in the debate. The G20 approach to derivatives was driven by a concern at the lack of transparency in the market and the quality of risk management. The planned trade repositories will give transparency. But, at the moment, regulators have an unclear understanding of the precise nature of the risks. Yet they are going to impose a mandatory solution, namely moving OTC derivatives, where possible, into exchanges and onto CCPs.
The regulator on the panel admitted they were still struggling with some quite fundamental issues. The repositories will give them data and they will be expected to be able to apply it to protect different parties. But they still have to agree how they will handle the data and what standards will be applied. It appears likely that they will get data from the repositories and only be able to use it after some time and a lot of development. This creates the serious risk that, during that inter regnum, any material and avoidable loss will be placed at their door. One doubts they like that moral hazard.
The panel had other issues of concern. They had no problem with CCPs, but they opposed mandatory use and felt there would be a political bias in adjudicating the capital backing for cleared versus bilaterally settled products. Extra territoriality issues are plentiful and European institutions may well decide it best to avoid the UK arms of US banks for fear of falling into the clutches of US regulation. There is legal uncertainty, especially when assessing the new regulations against national bankruptcy laws. Segregation and portability are good risk management tools but escalate the cost of operating in this area.
The consensus appeared to be that the G20 timetable was too rushed and would be flawed. The challenges are known, but not the unintended consequences. It would be more logical to slow down the whole process but the G20 2012 timeline for legislation is seen as an imperial mantra. And so, although implementation may be spread over a longer timeframe, the regulations appear likely to be rushed in all their abundance.
Well, as one panellist said in the debate. Six hundred US lawyers are busy writing the rules and 20,000 others are waiting to run a coach and horses through them!