The ongoing dispute between regulators in the U.S. and the European Union (EU) continues to hobble clearing operations in the over-the-counter (OTC) derivatives market, forcing buyside firms to look for a way around the gridlock and increasing concentration levels among remaining central counterparties (CCPs).
Worse yet, as market participants look for a way to continue using the OTC derivatives market, some buysiders are opting to go with non-cleared or “bespoke” derivative securities, while some clearing entities are exiting the business altogether. This exit of CCPs and other clearing firms is forcing the remaining clearinghouses to pick up the volume, said several market observers. They contend that this has made the market much riskier overall.
“It is the same set of issues being debated,” said Virginie O’Shea, senior analyst at Aite Group, of the continuing stalemate between EU and U.S. regulators. “They have been fixated on those for some time.”
Ironically, this regulatory fix, which was conceived by the G20 in 2009 and brought to legislative life in the Dodd-Frank Act a year later, was supposed to use mandated clearing to resolve the risk problems of the $700 trillion derivatives market, which bore much of the blame for the market meltdown and resulting global financial crisis.
Now, however, the global face-off over clearing issues such as regulatory equivalence and mutual recognition between the U.S. and European agencies has dragged on for almost 18 months, busting through several line-in-the-sand deadlines. Most recently, the EU extended by six months the December 2014 deadline it had set for regulators to reach an accord. (For more on the roots of the global clearing debate in OTC derivatives, see “The Coming Clearing Turf Battle” in the October 2014 edition of Traders.)
“There are rules for determining which regulatory regime you fall under, but cross-recognition is still being worked out,” said Phil Matricardi, a manager at Sapient Global Markets. “The industry is still just trying to make sure that they understand what activities will force them to comply with which regime, so that they hopefully only have to comply with one.”
Buyside Uncertainty
In late January, Sapient Global Markets released the findings of survey examining industrywide attitudes toward the changes in derivatives clearing. A total of 81 percent of respondents cited their greatest concerns as being the uncertainty caused by new regulations, the cost of compliance associated with new clearing mandates, and implementing a new technology solution. “Continued regulatory uncertainty and the lack of understanding of changing rules are top concerns for most participants,” the report stated, noting that “[t]he central clearing environment is creating more challenges for businesses to reach their revenue targets and make the necessary investments to meet new and evolving regulatory mandates.”
It was not supposed to be like this. The new derivative clearing regulations ordered the use of CCPs for clearing and prohibited so-called “bilateral swaps,” in which two parties conducted their derivatives business between themselves with only voluntary clearing. Many market participants, academics and lawmakers believed the new CCP regime would ease the systemic risk that bilateral swaps had wrought in sparking the financial crisis. Contrarians, however, pointed out that the risk was still there, just shifted to the CCPs, which might become the newest bailout beneficiaries in a future financial meltdown.
“I believe that the risk is still there, and inherent in CCPs, especially when they are mandated for the vast bulk of derivatives products,” said Craig Pirrong, a professor of finance at the University of Houston. He added that major banks and buyside firms like BlackRock and PIMCO, as well as organizations such as the International Swaps and Derivatives Association (ISDA) and the Bank for International Settlements (BIS), have been discussing CCP recovery, resolution and capitalization in several papers and statements. “All of these efforts are driven by the recognition of the systemic risks that would arise from a CCP failure,” Pirrong said.
Ironically, the CCP system didn’t get the market test regulators wanted. Not long after the passage of Dodd-Frank, the Commodities Futures Trading Commission (CFTC), led at that time by Gary Gensler, clashed with EU regulators on issues of recognition and extraterritorial and cross-border transactions, leading to the current impasse. Worse yet for the CCPs, this past summer the European Market Infrastructure Regulation plan delayed until 2016 the requirement that European buyside firms had to submit to mandatory clearing of derivative products. For the CCPs that had rushed to set up shop to accommodate the expected volume, the result was crushing.
Better news comes from the negotiations between the CFTC (now under Timothy Massad) and EU regulators, which may finally end the stalemate. “There are rumors circulating around the European Commission that an agreement between the EU and the U.S. is imminent,” said Aite’s O’Shea. “Although these have been false hopes before.”
Turning Down the Volume
On Jan. 29, the problems that have resulted from the OTC derivatives clearing mandate were detailed in a white paper entitled “Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank,” written by CFTC Commissioner J. Christopher Giancarlo.
In the paper, Giancarlo questioned how the derivative clearing rules were constructed and noted that the rules were “over-engineered and mismatched to the distinct liquidity, trading and market structure characteristics of the global swaps markets.” He had a theory as to why that was: The U.S. government and the CFTC itself were intent on “crafting a regulatory framework disproportionately modeled after the U.S. futures market.” As a result, non-U.S. buyside firms were actively avoiding doing derivative business with U.S.-based counterparties in an effort to bypass CFTC rules, he said.
Indeed, as Giancarlo and numerous others have pointed out, this unsettled state of regulatory confusion has taken its toll on volume in the OTC derivatives market. The market pulled back slightly, 3 percent, in the first half of 2014 (the most recent period for which there is data). The notional value of outstanding derivative contracts was $691 trillion at the end of June 2014, compared to $711 trillion at end of 2013, according to data from the BIS semiannual survey of the OTC derivatives market.
“There is regulatory overhang that is hurting volume,” said Sapient’s Matricardi. “But consistently low interest rates also hurt. There’s not a lot of volatility around zero.”
How the buyside firms are handling this time of uncertainty, Matricardi said, depends completely on the size of the firm and how much derivatives clearing business it does. “For a large firm, like a big fund or institutional buyer, things are OK because its clearing services are being taken care of by the broker or custodian, and those entities will bend over backward to serve a large buyside player,” he explained. Less certain is the fate of mid-tier shops or funds because their clearing broker or custodian may look at the amount of business coming from the smaller firm and decide it’s not worth the time and expense to help the firm comply with the new clearing rules, Matricardi explained. Often, smaller firms simply don’t have the infrastructure and staffing in place to respond to market necessities such as daily margin calls on derivative products, he added.
One thing buysiders are doing to handle all this uncertainty is simply avoiding derivative products that have to go through a mandated clearing regimen and instead buy bespoke products that don’t have to be cleared. “These bespoke derivative products that don’t have to be cleared may or may not be more risky, but often they are more expensive,” Matricardi said.
A bigger concern, of course, is that the continued delay over the clearing of OTC derivatives has already harmed the network of CCPs that were supposed to clear all of these products, according to O’Shea. All of this regulatory wrangling and lower volume has held back business from clearing brokers and CCPs in Europe, resulting in some brokers exiting the business as a result of the delays, she noted. Last year, two major banks, BNY Mellon and Royal Bank of Scotland, announced they were getting out of the derivatives clearing business. (In the U.S., State Street Corp. announced in December that it was closing its swaps clearing business and abandoning plans to open a clearing unit in Europe. State Street cited the new regulations and costs for its decision.)
That means, with fewer CCPs and clearing brokers in the mix, all clearing of OTC derivatives – and the inherent risk involved – will be done by a smaller and shrinking population of clearing entities. “So there are concerns about concentration risk for the limited number of clearing brokers on the market,” O’Shea said.
Where this all ends is uncertain, of course, and will depend greatly on a resolution of the feud between European and U.S. regulators. Once that happens, the world will get to see if mandatory clearing of OTC derivatives will be the market solution that legislators and regulators had predicted.
“I think we could see the quality of derivatives go up,” Matricardi said. “We also have the potential to have enormous trading and liquidity in this market, possibly to levels seen before the crisis. Except this time, it would be regulated, and that should help the buyside.”
