You may have heard that the signing of financial reform in the US wasn’t just the end of a long and difficult process but also the beginning of another, with a host of federal agencies given discretion to study and define the rules for the areas they oversee.
Thursday’s FT includes a comprehensive article looking at the unresolved issues for derivatives, and we think it’s worth highlighting a few of its main points.
The rule-making has been left to the Securities & Exchange Commission and the Commodity Futures Trading Commission, which will have to make nice and work together throughout the process. From the article by Aline van Duyn:
For the most part, the rules have to be written by July 2011. These are regulators that usually write just a handful of new rules every year but, thanks to the new legislation, there will be more than 100 definitions and rules to get through. …
Under the new regulations, the derivatives world will be divided in two. On one side will be those products that are widely used, simple in structure and actively traded: standardised derivatives. Those will be pushed on to clearing houses to make the financial system less vulnerable to the default of a big derivatives dealer.
And as you can see from this embedded chart, right now the global landscape for derivatives is dominated by the over-the-counter type:
So standardised derivatives will now be moved to central clearing houses to mitigate the risk of default and increase transparency. We’ve noted before how this process will have to deal with clearing-house procedures for resolving defaults — and might end up leaving CCPs looking more like GSEs.
At the same time, some of the unresolved issues for these clearing houses include more technical concerns:
Cleared derivatives will also have to be traded on electronic systems – although exactly how those systems will be defined, and how quickly and frequently price information has to be made public remains to be resolved.
And on the other side of the divide are OTC derivatives (emphasis ours):
No one knows what proportion will be uncleared, or what the targets are, although for all derivatives the more heavily regulated exchange-traded futures market provides the likely standard. “Look at the way futures have traded on exchanges,” says Viral Acharya, professor of finance at NYU’s Stern business school. “Similar practices, in one way or another, will be applied to OTC derivatives under new regulations. There will be more capital required, less leverage and less opacity.”
What else is left? From a chart attached to the article:
● Who qualifies as a “swap dealer”? A bank, an oil group’s derivatives trading arm, a small trading firm? How much capital is required?
● What type of swap will have to be cleared? Will regulators make clearing compulsory for large categories of financial instrument or take a case-by-case approach? Will there be limits on whether banks can own clearing houses?
● What kind of entity will qualify as a trading platform? Will trading over the phone be permitted or must it all be electronic? Must large trades be reported immediately? How much information about trades has to be made public?
● How much data do swap dealers and investors have to hand over to regulators, and how quickly? Who will be able to see this?
Van Duyn goes on to note the high stakes involved for the banks, exchanges, inter-dealer brokers and other financial institutions. As fiercely as Wall Street lobbied the government prior to the bill’s passage, expect it to continue for some time yet. Oh, and we imagine Warren Buffett is watching closely, too.
Related links:
Financial markets: Derivative dilemmas – FT
On clearing house concentration risk – FT Alphaville
A $3,000bn shift in the interest rate swaps market – FT Alphaville
Will SEC and CFTC see eye to eye on CDS – FT Alphaville