The risks of runaway regulation
While laudable in intention, reforms to Europe’s OTC derivatives markets may be in danger of inadvertently adding so much cost for participants that the original purpose is undermined, according to Anthony Belchambers, chief executive at the Futures and Options Association.
“The OTC markets did need reform,” Belchambers told Banking Technology. “Before the crisis, the banking party was getting out of hand, and the regulators came and took away their punch bowl. But now the question is, is the regulatory party getting out of hand, and if so, who is going to come and take their punch bowl away?”
Under the European Commission’s EMIR legislation, which was enacted in the UK in January, the majority of OTC contracts will have to be centrally cleared and reported to a trade repository. In addition, contracts deemed sufficiently liquid will have to be executed multilaterally, i.e. on an exchange or organised trading facility. The intention is to increase transparency and reduce systemic risk in OTC markets. A CCP acts as a central risk repository, reducing the danger to the market if a counterparty goes bust.
However, there are a number of issues with the new rules. Market participants will have to set aside collateral against their OTC positions; under Basel III, clearing houses may only accept high-quality, loss-resistant assets as acceptable collateral. But according to Belchambers, many financial market participants simply do not have that collateral available to them in the quantities needed to cover their trading and risk management needs.
Furthermore, since CCPs will need to adopt a safety-first approach in their role as repositories of risk, margin calls on relatively illiquid contracts are likely to be set high, especially if margin are set at a counter-cyclical rather than a pro-cyclical level. Secondly, margins are likely to be called on an intra-day basis, which may generate cash-flow problems for end users, and credit issues if the intermediary has to extend credit to cover the margin call. For Belchambers, the risk is that using a CCP could become uneconomic for some participants.
“If using derivatives to hedge risk becomes more expensive, some firms may cut back significantly on their use of derivatives markets,” he said. “The danger is that this may combine with regulatory efforts to clamp down on activities such as short selling, proprietary trading at banks, high-frequency trading, so that derivatives exchanges struggle to fulfil their risk-transfer role.”
Belchambers estimates that some 20-30% of contracts will not be suitable for clearing nor multilateral execution. However, legislation that mandates central clearing and multilateral execution may remove choice from market participants and place pressure on exchanges to list instruments that were never before traded on-exchange.
“There comes a tipping a tipping point in terms of liquidity when the contract is not worth listing,” he said. “The problem is that if the contract is mandated to be multilaterally executed, and the cost of clearing that contract is so high that you don’t want to use it, you won’t have the option to just do an OTC deal. Market participants will have no choice.”
Ultimately, the cost of new rules for OTC derivative may find its way back to the mainstream consumer, because participants that cut back significantly on their use of markets because of the increased cost of risk management may well decide to pass on the cost down the line to their customers. The firms that can afford closer management of risk through using an OTC product are likely to be the bigger institutions, so smaller or low-volume users stand to be particularly affected.
Collateral is also an issue in terms of supply and demand. Many market observers have already noted a general perception that there may not be enough collateral to service the needs of the entire financial community under the new rules. According to Belchambers, the pressure to accept collateral of a lower quality represents a severe tension between regulators and market participants that is unlikely to be resolved soon.
For Belchambers, some added cost in the wake of a financial crisis is inevitable, but the presence of too much regulation could have a stifling effect on innovation, damaging some of the very policy objectives that polticians and regulators hold dear, such as promoting lending, economic growth and responsible capital raising.
“We should remember that the market was created to fit the needs of end users,” he added. “Today we find ourselves in a situation where the regulator shapes the entire market, and the end users have to come up with the workarounds to make it viable. In my view, that’s the wrong way round. We need to be careful – there’s a growing awareness that we can’t go too far down this track, before it starts to erode the entire fabric of economic viability.”