OUT OF SYNC.
There is light at the end of the OTC tunnel but not all countries are heading in the same direction. Lynn Strongin Dodds reports.
The march to central clearing is finally underway with Japan and the US forging ahead while the rest of Asia and Europe aim to get their respective shows on the road next year. The problem though is that not all countries are going in exactly same direction and it is difficult to determine how their paths will cross.
This is not surprising given the sheer scope of the OTC derivative regulations. No one is refuting the need for central clearing with stricter mandatory reporting, margin and capital requirements for non-cleared derivatives transactions. However, as with any new rules, the devil is always in the detail and there are variations on the interpretation. This ironically begins with the exact meaning of a standardised derivative contract.
According to a recent report by Deutsche Bank entitled Reforming OTC Derivatives Markets: Observational Changes and Internal Issues, “despite the substantial amount of regulatory and technical documentation on this issue to date, there is no straightforward definition which allows market participants to easily distinguish a standardised contract from a non-standardised one?”
For example, in Europe, the European Market Infrastructure Regulation (EMIR) defines two distinct approaches – a bottom-up and top down. The former is where eligibility is based on the classes which are already cleared by authorised or recognised central counterparties (CCPs). The latter involves the European Securities and Markets Authority (ESMA) identifying derivative classes which nonetheless should be subject to a clearing obligation.
The regulator has a long checklist that includes common legal documentation, including master netting agreements, definitions, standard terms and confirmations which set out contract specifications commonly used by counterparties. It also comprises the operational processes of that particular class of OTC derivative contracts and whether they are subject to automated post-trade processing and lifecycle events that are managed in a common manner to a timetable which is widely agreed among counterparties.
By contrast, the US appears more straightforward. Its definition starts with the final rules defined by the CFTC that allow a Designated Contract Market (DCM) or Swap Execution Facility (SEF) to make a swap available to trade as a standardised contract eligible for central clearing. Following this, a DCM/SEF submits its determination for voluntary approval or through self-certification under CFTC Rules.
“Europe is being more ambitious than the US in converging rules for OTC and exchange traded derivative (ETD contracts), which may drive OTC volume onto standardised exchange based instruments,” says Jeremy Taylor, specialist in operational processing and derivatives at Rule Financial. “It also has a broader remit, but regional regulators have a slightly different interpretation of the rules. However, if we do not get harmonisation across both Europe and the US, then we will not have a level playing field and this will have unintended consequences for the way the landscape of the market evolves.”
“We have definitely come a long way since the G20 meetings in terms of getting the regulation ready,” says Ted Leveroni, executive director of derivatives strategy and external relations for Omgeo. “However, there are different rules and implementation timelines between the various jurisdictions. Harmonisation and co-operation would be a great benefit but it will take time.”
For now Leveroni believes that lessons can be learnt from the US experience. “What we have seen in the US is that it takes longer than expected to get ready for central clearing. Clearing and reporting under EMIR will not begin until next year, but buyside firms should start preparing at least six to eight months before, not three months before. At a regulatory level, I think the lesson will be that there needs to be standardisation in reporting between jurisdictions.”
At the moment, as the Deutsche Bank report shows, Dodd-Frank requires the mandatory reporting of OTC derivatives only while EMIR insists on both OTC and ETDs. This potentially means active funds could have thousands of pieces of data to be reported from a single day’s activity. The Europeans are more flexible though in allowing for end-of-day reporting although they require information by both counterparties while Dodd Frank wants the information in real time but only from one counterparty.
Jonathan Philp, capital markets consultant at everis adds, “There are still a lot of loose ends on both sides of the Atlantic but there has been a lot of frustration in Europe because ESMA has not yet approved any of the trade repositories, and there is still confusion over the final scope for listed derivatives reporting. I think that ESMA will approve a minimum of two TRs before the end of 2013, perhaps the DTCC and REGIS-TR, which will allow market participants to finalise their preparations for trade reporting starting in the 1st quarter of 2014.”
Other firms that are known to have thrown their hat into the ring include the UnaVista, the post-trade reporting service owned by the London Stock Exchange Group and Deutsche Börse-owned international central securities depository Clearstream.
Sandy Broderick, chief executive, DTCC Deriv/SERV, the DTCC trade repository group says, “The final step is to aggregate and harmonise the data globally. For now each jurisdiction varies slightly and has different delivery systems. For example, the larger buyside firms are ready either via their own internal systems or through a third party. Some of the lower volume firms use spread sheets. No one yet has an industrialised process because they are managing so many things at once. However, this fragmented approach could prove challenging over the long term.”
Another obstacle could be in finding the right collateral to meet the more onerous margin requirements but predictions of a squeeze have been greatly exaggerated, according to Committee on the Global Financial System. Estimates varied widely last year with the International Swaps and Derivatives Association reporting that derivatives may need $10 trillion (£6.62 trillion pounds) in initial margin on trades while others put the figure under $1 trillion.
The committee of central bankers, which questioned these figures in a recent report, noted that “current estimates suggest that the combined impact of liquidity regulation and OTC derivatives reforms could generate additional collateral demand to the tune of $4 trillion spread out over the next several years. Hence, concerns about an absolute shortage of high quality assets appear unjustified. However, the supply of such assets used for collateral in 2012 was about $48 trillion to $53 trillion.
It is not surprising given the more muted tones that collateral management may not be the revenue generator that many broker dealers had hoped. “I think the sellside is waiting for the dust to settle before they fully recalibrate their models,” says Bradley Wood, partner at GreySpark Partners. “Collateral optimisation has been talked about but it is not yet a done deal. At the moment banks have sufficient liquidity to offset any trade exposure and they are not yet using their inventories. As for the buyside, they may prefer to trade liquidity swaps in the beginning.”
Jim Malgieri, head of GCS (Global collateral services) at BNY Mellon adds, “Because regulations are just coming into effect, there isn’t a huge uptick in the use of collateral yet but I agree that the requirement will be nowhere near the higher figures. I think it will be more in the $750bn range which is still a big number. For now, though, there is still a lot of liquidity in the system and most clearinghouses will accept cash.”