The legislative drive to regulate over-the-counter derivatives continues on both sides of the Atlantic. A unified directive is still looking hazy as regulators move toward deadlines for new standards.

Regulation seeking to overhaul the $600 trillion over-the-counter (OTC) market is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the mammoth piece of U.S. legislation drawn up in response to the financial crisis of 2008. Similar, but not identical, regulatory structures are being drawn up by the European Union (EU), which will affect OTC markets across Europe.

The undertaking is daunting, as it ushers in "a new era of trading styles and protocol based on new platforms," says Andy Nybo, principal and head of derivatives research at TABB Group, a research and consulting firm.

"It’s a huge endeavor to transform the industry," including transitioning certain parts of the OTC marketplace that are still voice-executed to electronic trading, he notes.

"We are definitely trying to push this process forward," says Andrew Sterry, European head of derivatives intermediation and derivatives clearing at Citi Prime Finance, and a CME clearing client on both sides of the Atlantic. "But people are seeking clarity on the rules," he adds.

Hanging over the unclear picture in the U.S. and Europe is the possibility that market participants could shift OTC activity to growing Asian markets because of their friendlier regulatory policy, a process known as regulatory arbitrage.

One point that is clear is the Dodd-Frank requirement that standardized swaps must be cleared and guaranteed by clearinghouses and traded on either an electronic exchange or swap-execution facility (SEF). The rule seeks to give the market greater transparency and mitigate concerns about mutual credit risk between trading counterparties.

Certain aspects of the proposed legislation "will absolutely improve the current marketplace," Nybo says.

In a study released in July 2011, the TABB Group said central counterparty clearing (CCP) services "will change the counterparty risk equation...CCPs don’t remove counterparty risk, but they do strongly mitigate it. More important, when a trade is cleared it no longer matters who’s on the other side of the trade – the CCP is the buyer to every seller and the seller to every buyer."

The cry for clearing

The broad global agenda that is changing the OTC landscape was set in motion in September 2009 at a meeting of the G-20 industrialized nations in Pittsburgh, held one year after the failure of Lehman Brothers Holdings. The G-20 agreement called for standardized OTC derivative contracts to be traded on exchanges or electronic trading platforms and cleared through central counterparties by the end of 2012 at the latest.

In addition, the G-20 said OTC derivative contracts should be reported to trade repositories and that noncentrally cleared contracts be subjected to higher capital requirements. Clearinghouses around the world are now gearing up for their expanded role in OTC markets.

CME Group has transferred its experience in clearing exchange-traded financial derivatives to include clearing of OTC financial products, such as credit and interest-rate swaps in the United States. Now it is looking to do the same in Europe through CME Clearing Europe. Launched in May 2011, CME Clearing Europe currently clears energy, agricultural and freight products, and plans to clear interest-rate swaps and credit default swaps.

Interest rate contracts represent the largest OTC market segment, with a notional value of $465 trillion as of December 2010, according to the Bank of International Settlements. Credit-default swaps (CDS) logged a notional value of nearly $30 trillion in December 2010.

"Rate products in particular will benefit from centralized OTC clearing, as they will be listed on the same venue," says Sterry.

Location, location, location

Andrew Lamb, chief executive officer, CME Clearing Europe, notes that London is a gateway to Europe because it is home to a large community of international banks and nonbank financial firms, hedge funds and institutional investors. In addition, clearing in London may offer a geographic advantage for certain derivatives products, particularly during this period, when uncertainty over the final rules has added a layer of complexity to market dealings.

In addition, "European clients want to stay within the European framework," adds Sterry.

The European Market Infrastructure Regulation (EMIR) is still in draft form, and is "quite compact" compared with the Dodd-Frank legislation, says Lamb. "Generally speaking, the EU process — called the definition of standards — is quite a bit behind the more ambitious timetable set in the United States," he adds.

"The obvious difference between the United States and the EU is that change at the EU level involves discussions between 27 member countries, many of which have very small financial services sectors and little by way of experience with OTC derivatives markets," Lamb explains.

Ready, set, clear

Despite regulatory delays on both continents, "clearing accounts are now being set up, swap execution facility aggregators designed, and trading strategies examined," the TABB Group notes in its study, "Higher Frequency Swaps Trading: Market Making and Arbitrage." The report suggests the ongoing OTC derivatives reform is "setting the stage for some long-overdue market innovation."

Nybo says once the legislative landscape is finalized, the marketplace will quickly embrace central clearing for swaps. Vendors are currently building out platforms in anticipation of final rules and already have invested in solutions to support standardized swaps, he says.

There is, however, some ongoing debate about some of the regulations proposed as a result of Dodd-Frank. One proposed rule would require that 85 percent or greater of the total volume of any contract listed on a designated contract market (DCM) be traded on the DCM’s centralized market, as calculated over a 12 month period. Some in the clearing industry, including CME Group, have opposed this proposal as an arbitrary one not required by Dodd-Frank.

Another rule under debate between clearing firms and the U.S. Commodities Futures Trading Commission (CFTC) is the proposal for a "complete legal segregation model," where the open positions and collateral of cleared swaps customers would be comingled on an operational level. However, in the event of a default in a customer’s cleared swaps customer account, a derivatives clearing organization would be permitted to access the collateral of non-defaulting customers in order to cure the default.

Then there is the question of whether OTC clearing will add liquidity as well as transparency to the market. "Central clearing is part and parcel of futures markets and is generally accepted as a key factor behind the liquidity that is so notable, particularly in benchmark products," says Lamb. "Open interest in CME Group’s interest rate products stand out in that regard."

Similar to futures trading practices, an OTC order under the reformed OTC structure order might begin with a client, move to a broker-dealer, then to a SEF, before ending at a CCP. Credit-default swaps were under particular scrutiny by regulators, as both the failed Lehman Brothers and American International Group Inc.(AIG), bailed out by the U.S. government in an $85 billion deal, were active CDS traders.

Expressing the regulators’ view, CFTC Chairman Gary Gensler told an industry conference last spring that "the financial crisis demonstrated the risk to the public of ineffectively regulated swap dealers."

"While banks and securities firms were regulated by their prudential regulators, their affiliates that traded swaps often were left ineffectively regulated — that was the case for Lehman Brothers and AIG," Gensler said.

"The industry is not sitting around twiddling its thumbs" while regulators fine-tune the process, Nybo says, "but there are roadblocks and challenges. Not the least of those challenges is the lack of regulator harmony in Europe and the U.S."

"Accommodations will be made," concludes Nybo, "but I do not expect the same set of regulations will be used in the U.S., the U.K. and Europe."