Industry “not ready” for OTC derivatives reform

Most firms are still not ready for new rules on OTC derivatives

Four out of five financial institutions are not ready for new regulations governing the trading, reporting and clearing of OTC derivatives, according to a new survey by communications company IPC.

Under new regulations currently being introduced in the G20 nations, the vast majority of OTC derivatives must be centrally cleared and reported. In the US, Dodd-Frank mandates the trading of swaps on a new type of trading platform, the swap execution facility; in Europe, EMIR will require centralised reporting to a CSD and clearing with a CCP by Q2 this year.

However, of the hedge funds, investment banks, broker-dealers and exchanges questioned by IPC, some 36% reported that their company did not have a plan in place to deal with new regulations, while a further 62% said their firms were not well prepared, leaving only 19% who believed the industry was ready to meet the new rules.

The lack of preparation belies the current scale of OTC derivatives trading; some 94% of the firms that responded to the survey are already trading OTC derivatives or plan to do so in the next six months, while 74% expect their firms’ trading volumes to increase in the next year.

“Connectivity to SEFs and the various other OTC derivatives execution venues is critical not only for addressing compliance concerns but also for gaining competitive advantage and capitalising on new opportunities,” said Ganesh Iyer, senior product marketing manager at IPC.

Adding to the difficulties unprepared financial institutions must face, under Basel III banks will have to set aside more collateral. With OTC derivatives classed as a higher risk investment, firms that continue to use customised bilateral contracts will need to pay substantially more in margin costs.

Some of the lack of preparedness may reflect ambivalence about the new rules. Some 26% of respondents to the survey believed the benefits of new regulation would far outweigh any associated costs, but they were outnumbered by the 31% that thought the rules would have a more negative impact, leading to increases in the cost and complexity of trading. Digging deeper into the results, scepticism about the effectiveness of new regulation was also widespread; only 29% of respondents expected new regulations to actually achieve their stated goal, which is to reduce systemic risk.

On the positive side, 57% did expect the new regulations would increase market transparency, with just over half (53%) citing this benefit as moderately or critically important.

The IPC findings complement a similar study released by BNY Mellon and Rule Financial in December, which found that the situation is even worse among buy-side firms. According to the BNY Mellon/Rule Financial joint paper, To Clear or not to Clear … Collateral is the question, only 20% of asset managers have finalised their adjustments to meet the new rules.

The cost to financial institutions arising from these new rules has sparked fears among some market participants that there will be a substantial shortage of collateral one the new regulation takes full effect. That expectation led earlier this month to an announcement from the central securities depositories in Germany, Spain, Brazil, South Africa and Australia that they had formed an alliance that aims to tackle the expected global shortfall in collateral. Dubbed the ‘Liquidity Alliance’, the group consists of Clearstream, Iberclear, Cetip, Strate and ASX respectively. The five companies will meet each quarter to work out the most efficient way of dealing with collateral and to discuss partnerships, commercial opportunities and key issues.

Meanwhile, Citi has also been working to change the way that broker-dealers manage their collateral to take account of the new rules. In January, the firm established a set of alliances with Clearstream and Euroclear Bank, under which the tripartite agent managing collateralisation will now instruct the collateral moves on behalf of the broker-dealer, simplifying the process and thus potentially making it more efficient.