Uncertainty reigns supreme in the grand regulatory re-ordering of the US derivatives landscape, with few capable of predicting how costly, beneficial, punitive or distorting Dodd-Frank will prove. The industry is readying itself for implementation assuming the worst, ensuring any risk is on the upside. There have been plenty of reports of banks cutting loose prop trading desks, for example, in anticipation of the Volcker rule.
For many end users the impact is likely to be more limited, as regulators have where possible tried to put the burden on banks. “Most corporates don’t want to clear their OTC trades due to the collateral requirements it entails, so it will be largely business as usual for them,” says Joyce Frost, partner at Riverside Risk Advisors, a US-based consultancy.
But there will be significant consequences. Extraterritoriality is a particular concern for non-US businesses with US operations, and the Commodity Futures Trading Commission’s (CFTC) guidance on the subject raises more questions than it answers. It subjects market participants to swap dealer and major swap participant registration and mandatory clearing for certain trades, without a clear definition of US person the market can rely on after July 12 2013. The interim definition also leaves doubt as to who is caught by the CFTC rules.
“The taking of collateral in the US by way of security interest, and in the UK by way of title transfer, as well as parochial insolvency regimes that favor creditors within the jurisdiction, create very complex issues that need to be resolved to ultimately achieve the regulators’ goals,” says Donna Parisi, a partner at global law firm Shearman & Sterling.
There is concern the CFTC’s position will push derivatives activity offshore, with Europe and Asia behind the US in terms of implementation, creating the potential for regulatory arbitrage. However, “this trend may be countered by the high collateral and capital requirements, new financial taxes and pay restrictions that are playing out in Europe,” says Parisi.
Yet even within the US there is scope for inconsistency: “The SEC has yet to issue its extraterritorial guidance with respect to the products it regulates and it may prove to be inconsistent with the CFTC’s ultimate position,” warns Parisi.
In the securitisation market many SPVs have a rating agency requirement to hedge cashflows using swaps. Aspects of Dodd Frank make this very challenging for the rating agencies and investors. A clearing requirement, or the need for cash collateralisation in the case of an OTC exception, would be problematic because the mark-to-market on swaps can be volatile and would affect daily cash movements. “It is another example of an unintended consequence that could significantly affect the market,” says Frost. Mortgage lenders, which use swaps to offer fixed rate mortgages, are also nervous about the implications collateral rules will have on them.
Expanded reporting requirements requiring all derivatives trades be reported to the CFTC may catch end users out, though it is theoretically seen by many – including the International Swaps & Derivatives Association – as among the biggest benefits Dodd Frank will bring.
But even improving reporting has been more complicated than originally anticipated, due to the huge discrepancies in market practices that have arisen while the industry was unregulated.
It is a similar story in other areas of the rules. Complexity is essentially translating to cost, though the new regulation will at least have the advantage of making banks more transparent in the pricing offered to their clients, says Frost.
The cost is especially burdensome for the smaller banks and corporate end users that do not have existing systems in place, or the scale to easily justify the expenditure. The added cost could result in mid-tier players exiting the market, leading to an increased concentration of the business in the hands of a smaller number of big banks.
“The industry needed more discipline and regulation but Dodd Frank still seems like an overreaction,” says Frost. “It goes much further than what is needed and is an unnecessary resource drain, on both banks and end users, struggling to understand and comply with the rules. I think the regulation could have been delivered more simply and cheaply without compromising effectiveness.”
“Market participants have come to terms with the fact that the derivatives are subject to increased regulation,” says Parisi. But the absence of clarity with regards to the four aspects of the regulation – on margins, trading, cross-border dealings and the Volcker rule – is sapping liquidity and business activity, she adds.