Dodd-Frank is law

The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law on 21st July 2010.

The Dodd-Frank law being passed in the US Senate drives the concept of on-exchange OTC Derivatives.

There have been some pressure groups, particularly amongst the major banks, which have been pressing for this to be relaxed. But as this is now on the statute, this change to the OTC markets will happen.

The question now is in what order the OTC products will move to a more regulated a environment, and at what speed the market participants can implement the concepts required to achieve this, such as cross market limits, transparent price discovery and central clearing.

Rules in the making

Due to the size and complexity of the OTC Derivatives market, estimated at $615tn, and the range of products traded OTC, the rules to enforce Dodd-Frank are still being interpreted and debated.

The CFTC are charged with generating the rules for Swaps in the US, with the exception of those with underlying securities that fall under the SEC jurisdiction. Both the CFTC and the SEC need to work together to produce rules around the execution of OTC derivatives.

As a consequence of the split, the fact that the European exchanges and regulators are now looking at their own regulation, and the continuing work to understand fully the market involved, there is a sense of speculation around the way that these products will be traded. Every market regulator or representative body is commenting on every ruleĀ from the CFTC and SEC, and very publicly. And these comments lead to the uncertainty as to what the CFTC and the SEC will finally implement.

One thing is sure, that they will regulate this market.

“Push-Out” provision

One major complication, which will directly affect the swaps dealers and the Major Swap Participants (MSP’s) is the push-out provision, which will force banks with government insurance for losses, to separate certain types of their swap business, including Commodity, Energy, Metals, Agriculture, CDS on non-investment grade entities, uncleared CDS and Equities, from their Deposit Taking businesses.

The implications are that they have to cease these businesses, or set them up in a separate, highly capitalized entity. This will have major implications for the processes involved, and adds to the changing environment required within a number of the large market players in the OTC markets.

SEF’s and their impact

The Swap Exchange Facility (SEF) is a key factor in being able to more fully regulate that OTC market place. The CFTC and the SEC are working towards defining the methods that will be used for moving OTC products onto electronic marketplaces. The sheer scale of products involved, and the complex nature of some of them makes this an onerous, and contentious process.

Market Making Participants on a SEF will have to give prices on the instruments within the SEF. This pricing process will to all intents and purposes look a lot like other exchanges / ECN’s. The complication with Derivative products is the wide range of products, and the difficulty in fully commoditizing those products.

What is required on the SEF environment:

– Provide two way pricing on a Swap product from Liquidity Providers to Buy-side firms.

+ The contentious point here is the concept that the buy-side participants can also make prices to other participants. This makes the whole credit risk and margining process very complex, and a participant failure could cause unwind issues.

– Work in either a Request For Quote basis, with a minimum of five quotes per request, or in a Closed Limit Order Book basis, where there are executable bids and offers.

+ The RFQ being forced to be five is very difficult in illiquid markets, and out of normal market hours

+ The CLOB concept works for more security like products, but for derivatives with wide variations of tenor and strike, and multiple pricing parameters, this is not workable

+ The market view of the CFTC requirement for either RFQ or CLOB SEF execution facilities is that this is too restrictive. There may be a need for reverse auction, nearest match, matched execution or other variations in the future as the markets become more defined. The SEC and ISDA have both raised concerns on this issue, and in fact the SEC rules are more open than the CFTC rules.

– All end-user participants on the SEF must have a credit agreement / margin contract with the providers that they transact with.

+ In some OTC markets today this is not the case, and this will add an additional financial burden on doing business in these products, which may cause some participants to stop trading these products.

As with all electronic markets as the rules firm up, and the anxiety around how to trade moves being able to trade, there will be more liquidity, and almost certainly more volume in the SEF eligible products. One unwritten rule to date is to ensure that all participants understand and manage the risks involved in trading these kinds of products. The more complex the structures listed on SEF’s, the more chance that in spite of margin or collateral agreements, we may see failures of market participants, as we have in past markets such as unlisted options and CDS’s.

Central Clearing

Central Clearing of eligible products is another key factor in the regulation of the OTC marketplace.

This will apply to a number of vanilla products. For example ISDA estimate that 90% of all OTC IRS products dealer to dealer at centrally cleared today. The issue will be clearing the buy-side products, with limited participants able to do so directly, this will fall to the custodians and prime brokers to manage and provide this facility.

One key area of uncertainty in central clearing are FX Swaps and Forwards. At present these are within the remit of the rules that require these to be centrally cleared, although there is a proposal in front of the US Secretary of the Treasury to specifically exclude these products. This is a $60tn market today, and the change would be a significant one.

In the FX product space Continually Linked Settlement (CLS) manages 17 major currencies, covering around 95% of the global FX market, and providing Payment vs. Payment processes. There is a view that CLS actually solves many of the problems that Central Clearing is aiming to solve, and so an exemption for these products makes sense.

Other than FX products, there is an acceptance of Central Clearing as a benefit generally to the participants. The key issues are changing processes to support this are complex, and have a long time to market, probably longer than the regulators are looking to allow.

Overall impact

The overall impact of regulation in the OTC Derivatives markets is likely to be very positive. But much of the concern is about the lack of flexibility that is in some of the current rulings for market transactions, and the timeframes for implementation.

With the impact of SEF’s, Central Clearing, increased Margin / Collateral requirements, more rigorous reporting and the “push-out” provisions, there is a considerable amount of effort needed within the swaps dealers and major swaps participants.

Whether all the requirements can be met, in the timescales the regulators need, once the rules are finally agreed, without impacting the OTC market place remains to be seen.

As with all market changes, this will happen, but the cost could be significant to the key players in this space, and even to the end-users looking to transact using OTC products.

worldflow will continue to monitor this space for changes and clarity, and try to interpret the impact on behalf of our clients, our FX Options ECN Digital Vega, and the market in general.


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