Monday, May 10, 2010

Q&A: Evolution of the OTC Derivatives Markets

Posted on by John Avery, Partner at SunGard Consulting Services:

Q: Are the OTC derivatives proposals currently being considered the right move for the industry?

A: To paraphrase Darwin, "evolution happens". I think "some sections" of the current proposals are simply natural evolution for the unregulated, bi-lateral OTC derivatives market. It's more than just coincidence that the same Timothy Geithner was an active advocate five years ago for reducing systemic risk in bi-lateral post-trade operations when he was running the New York Fed.

I also think the movement to regulate this market is well outside the hands of the industry itself at this point, so it might be better to ask if the industry has had enough of the "right" objective input into the current proposals for reform. ISDA and SIFMA have been evolving the industry in parallel with reform and have advocated very well, accurately representing the industry and doing their best to contain the "witch hunt", so I think that in general, the industry has indeed defended itself well against most of the regulatory response.

OTC derivatives markets have served and will continue to serve an important function in the market, with nimble, tailored products that permit the dissection and dispersion of a number of key business risks throughout a broader range of market participants. Once the political dust settles, balanced regulation will ultimately do well to increase transparency to a point where enough of the right eyeballs can ensure that fundamental principles for OTC derivatives remain sound, which was not the case leading up to the credit crisis.

Q: What are some benefits/negative effects to the derivatives space from the proposed regulation?

A: Reduced systemic risk and reduced counterparty credit risk will increase awareness and use of OTC derivatives for portfolio managers and end-users who can leverage the behavior they offer.

Immediate negatives for the big dealers are reduced margins, increased capital requirements, client collateral re-hypothecation constraints, and increased house funding constraints that, when combined together, can have dramatic economic consequences. Uncertainty for all other market participants on exemptions, margining, and capital treatment across the gamut of products they use will also have economic consequences that have yet to be fully explored.

An obvious other impact for participants will come in the form of significant capital expenditures in operations, technology and compliance, however the long term benefits of these investments will ultimately yield a more scalable, risk managed infrastructure to serve the industry for years to come.

Q: In your opinion, will the proposed bill pass with the current OTC mandates intact?

A: I think Clearing, Transparency and Swap Execution Facilities have quite a bit of support and will likely make their way into the final legislation, as will some set of End-User exemption behavior. The Volcker Rule is quite contentious - and one that could have dramatic disruptive economic consequences if immediately forced upon the industry - so it's likely that cooler heads will prevail and a more balanced, bi-partisan bill will find its way to Obama's pen.

Q: Do you think OTC derivatives are being vilified by Washington?

A: I think they're an easy target and it's unfortunate that the entire apple cart of OTC derivative instruments has been upset by a few bad apples that contributed to the credit crisis.

Q: What will derivatives traders and other market participants have to do to be compliant with the pending regulation?

A: This is a great question that very few are asking right now and will ultimately catch most of the industry off-guard. We've been looking at this for quite some time within SunGard, because we have a responsibility to our clients to help them with answers and solutions.

At face value, the move from an unregulated to a regulated market is not one that can be taken lightly. Clearing, Swap Execution Facilities and Trade Repositories are the obvious immediate operational compliance requirements, but it's the non-obvious hints we glean from other markets that we must be cognizant of.

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