Deciphering the new map

Two key themes – liquidity and risk – always rise to the surface of any discussion around the implementation of regulation for OTC derivatives trading in Europe and North America. A couple of recent articles in The Economist neatly outline both sides of the argument by discussing risk, potentially increasing transaction volumes and strategic business opportunities arising from the current regulatory direction.

Before the meltdown, it was common knowledge that most banks had a huge backlog of swaps transactions (valued in hundreds of millions of dollars per bank) sitting in their back offices for clearing and settlement. Bringing the majority of these deals (the less bespoke ones) into the existing clearing/settlement mechanism would do two things. First, it would remove settlement backlogs as CCPs would most likely work within mandated settlement time frames, providing a more accurate picture of risk versus the ripple effect as a default reverberates unpredictably through back offices. Second, it would provide the level of transparency into these transactions required to attract greater market participation, which may actually increase liquidity. Consolidating risk with the clearing facilities doesn’t remove the risk of another large scale corporate default, which in the past triggered a rapid and industry-wide downward spiral, but providing a clearer picture of the potential magnitude and locality of the damage makes it easier to plan a more effective and focused response. This Economist article elegantly frames the debate and asks whether we are manufacturing a situation whereby entities really are “too big to fail”. To draw a parallel with the natural world, because we know that earthquakes are mostly concentrated where continental plates meet, we know where to look for risk and how to monitor and measure it, and develop robust emergency response procedures accordingly. Mandating that OTC derivatives trades be cleared through CCP’s will allow us to know where the risk is, and how to monitor and measure it, leaving central bankers and governments to develop the necessary emergency response procedures.

The current regulatory moves in Europe and the US will certainly have some unexpected results, beyond the purely operational. Interestingly, some of the recent M&A activity among large exchange operators has been with a view to expanding or strengthening business lines involved in the OTC product space. Undoubtedly more corporate maneuvering is yet to come, and with greater variety, as the industry on both sides of the Atlantic comes to understand all the opportunities that this regulatory evolution provides. Another article, also in The Economist, effectively illustrates how the LSE and Deutsche Bourse are translating, or have tried to translate, regulatory change into business strategy. It could be argued that rather than stunting the growth of OTC derivatives trading, the regulatory change currently underway may do the reverse, either through greater market participation or through stronger and more diverse business entities. So it appears that liquidity and risk will continue to be key themes in the evolving debate as we move towards implementation of new regulations on both sides of the pond.

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