The Federal Reserve Bank of New York put out an interesting release on Tuesday related to regulation of over-the-counter markets (H/T Chris Cook). Within the statement, which relates to a promissory letter undersigned by most of the banking world, it reads:
“As has been widely recognized, the OTC derivatives market has been exposed as a source of excessive risk. Achieving these commitments is an important step toward managing that risk, making the financial system more resilient and robust. We will continue to demand further improvements until our objectives are achieved,” said William C. Dudley, president of the New York Fed.
The objectives include expanding use of central counterparties, strengthening risk management and operations, significantly improving transparency and ensuring strong coordination within the regulatory community. Key elements of the letter include establishing, for the first time, deadlines for recording all credit, interest rate and equity derivatives transactions in trade repositories and expanding credit default swap (CDS) central clearing to buy-side firms.
All of this, of course, comes in the context of the ‘opaque’ credit default swap market becoming the poster child for what brought us into the current crisis via the industry’s excessive counterparty risk exposures etc.
Accordingly, the undersigned promise to work towards:
We reiterate our commitment to reducing systemic risk in the OTC Derivative Markets through the following:
• Implementing data repositories for non-cleared transactions in these markets to ensure appropriate transparency and disclosure, and to assist global supervisors with oversight and surveillance activities.
• Clearing for OTC standardized derivative products in these markets.
• Enabling customer access to clearing through either direct access as a clearing member or via indirect access, including the benefits of initial margin segregation and position portability.
• Delivering robust collateral and margining processes, including portfolio reconciliations, metrics on position and market value breaks, and improved dispute resolution mechanics.
• Updating industry governance to be more inclusive of buy-side participants.
• Continuing to drive improvement in industry infrastructure as well as to engage and partner with supervisors, globally, to expand upon the substantial improvements that have developed since 2005.
But while the rules won’t just be related to the CDS market, including, as they will, interest rate derivatives and equity derivative trades too, one area they do seem to circumnavigate for the time being is the world of commodities OTC trading.
With most of the world’s physical commodity transactions still being done in the opaque OTC market, only price-finding agencies like Platts and Argus currently offer any element of transparency.
These agencies, however, only dip into a small slice of the OTC market and are not supported by any regulatory powers. They only manage to collect data on the basis of a symbiotic relationship with the industry, which needs benchmark prices to settle trades against. Most of the key benchmarks produced — and which go towards influencing futures prices across the world — however, are based often only on small pockets of the market sometimes dominated by certain industry players.
So the issue here is not so much one of counterparty risk but a question of just how well the market can protect itself from potential manipualation arising from some of these processes.
Chris Cook, the former head of compliance and supervision at International Petroleum Exchange, certainly believed that some of the inexplicable price moves in the market last year may have been down to this.
Accordingly, Cook told a Treasury Select committee back in July 2008 the industry desperately needs some sort of transparent registry for oil trading to counter the potential for manipulation of prices. This is much like the registry now being pitched for the CDS market. As he told the Herald at the time:
“Consumers urgently need this because they fear they are being ripped off, and if they are not being ripped off they have no way of knowing the fact.”
He believes there is enormous scope for price-fixing in the industry because most oil transactions are based on the delivery prices of Brent, Forties, Oseberg and Ekofisk oil – essentially North Sea oil. But with just 70 cargoes of 600,000 barrels produced each month with a total value of around $5bn, it is dwarfed by an estimated $260bn invested in the energy sector, much of it borrowed and much of it controlled by investment banks and hedge funds.
Of course, one key side-effect of Lehman’s failure last September was in fact a rush of commodities OTC clearing business to central clearing houses. The CME, for example, saw its volume of off-exchange energy settlements rise by a third in the first quarter.
Nevertheless, there are some signs the industry is moving towards going back off-exchange, in which case some sort of formal inclusion of the commodity markets in the current OTC-busting moves would eventually make sense.
Although, most likely, we will have to wait until oil is back over at $147 per barrel for the necessary sentiment to make it happen.
Platts versus the rest of the energy trading world – FT Alphaville
Whatever happened to speculator limits on Nymex? – FT Alphaville
Wall Street makes significant concessions on OTC derivatives – FT Alphaville