OTC derivatives market participants still lack clarity in regulatory reform and thus the knowledge to evaluate how a financial firm’s role in the new OTC marketplace will change and whether staying in the game is worth it?
Regulatory reform will step up in 2012 as rules are expected to be confirmed in both the US and Europe despite the delays and distractions of 2011, when financial institutions remained on the fence while waiting for rules to be confirmed. With clarification of the rules, financial institutions will now have the information (not assumptions) they require to finally evaluate how their new role and participation in the reformed OTC space will operate, and more importantly, what this will cost.
There is no doubt the cost of participation in the OTC markets will rise. And there are various figures claiming to pinpoint the cost of regulatory reform – to the industry as whole and specific sectors within the industry. However, cost is a relative term which does not simply refer to a price tag for operational change, moreover the staffing required and time spent away from revenue generating activities as well as the impact new rules will have on the overall business model of a firm. The cost of central clearing, a requirement under both EMIR and Dodd-Frank and the G20 commitments, is still completely unknown as the specifications such as minimal capital requirements of CCP membership, the cost of clearing trades centrally and even the range of instruments that will be cleared centrally have all yet to be determined.
The larger OTC market participants, and brokerage firms that can potentially build revenue-generating business via client clearing services will no doubt stay in the market, but smaller firms (both buy-side and sell-side) will need to evaluate if they should exit this space due to the higher cost of compliance and operations. The simplest way to do this evaluation is a return on investment (ROI) analysis to assess if the upfront costs yield significant profits. For some firms, such a ROI or cost/risk analysis may reveal that it is in fact no longer cost-effective to stay in the OTC markets.
Many firms will have already done this assessment but for others, the level of participation for some market participants has yet to be determined before such cost analysis takes place. Even those, such as pension funds, that may be exempt from some rules, will have to alter legal contracts and other procedures to meet the new practices of a reformed derivatives landscape and the requirements of other regulation, such as Basel III.
And the rulemaking process may hit more delays as we head into 2012. Upcoming political events including Denmark taking over the EU presidency from Poland this year and the upcoming US presidential elections (and the chance of a change in leadership in Congress) may delay rulemaking somewhat and some expect the changes could weaken proposed regulatory reform. However, a full repeal of the Dodd-Frank Act and game-changing alterations resulting from these potential political shifts is unlikely. In fact, the most pressing change is likely to be the introduction of new capital and collateral related requirements resulting from the MF Global default debacle. Also, ongoing debate on the specific rulings such as the Volcker Rule is one everyone is watching.
For the firms that do decide it is worthy of staying in the OTC space, or have already made the decision, the strategy will likely be one mixed with short-term and long-term goals. Data management is one of the initial steps that firms are taking to prepare for reporting requirements under the new rules. Financial institutions will need to be able to collect all the relevant data to meet new reporting requirements and this is a huge undertaking for firms lacking centralised data management facilities. This immediate focus on data is compounded by the expectation that the Financial Stability Oversight Council (FSOC) is expected to finalise the first systemic risk related rules in the coming months in 2012.
In addition to the compliance requirements projects, the firms that are ahead in preparation plans are already beginning to think about opportunities. Such opportunities are sure to become more visible as clarity in the rules comes to be but many already have their eyes on collateral optimisation as not just a way to manage capital requirements more efficiently but possibly a revenue generating activity. Other innovative ideas are sure to come next but the opportunities may not be lucrative enough to counteract the rise in costs market participants will have to manage to stay in the OTC space.
