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IPE special report May 2018

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OTC Swaps Regulation: Unintended consequences

The complexity and expense of complying with new collateralisation rules in the OTC market could encourage more risky practices, finds Anthony Harrington

One of the first rules of regulation should be that the benefits outweigh the costs. At first sight, that looks easy to achieve as far as the regulation of over-the-counter (OTC) derivatives is concerned.

In the run-up to the 2008 crash, asset-backed securitisations spread the poison of the US sub-prime housing market through much of the developed world's banking system, causing massive counterparty concerns and a near catastrophic credit crunch; demanding greater transparency has not been controversial for politicians. The cost of the 2008 crash was tentatively put at €2.3trn by the Bank of England in 2008, but if the European sovereign debt crisis is costed in as part of the legacy, the real figure is probably orders of magnitude greater. If one takes the view that transparency in the derivatives sector could stop a similar crash from happening again, then the cost-benefit analysis makes itself.

What is certain is that the lack of transparency in the vast OTC derivatives market has been identified as a major systemic risk by the G20 group, and since the transparency problem in these markets stemmed from the fact that deals were bilateral, then forcing as many transactions as possible through central counter parties (CCPs) and registering the rest through securities trade repositories would cure this by creating instant visibility.

Ethiopis Tafara, the director of the Office of International Affairs at the Securities and Exchange Commission (SEC) summarised the official regulatory view in March this year in testimony to the House Subcommittee on Capital Markets: "One of the lessons of the 2008 financial crisis is the importance of ensuring that regulators have timely and comprehensive data about over-the-counter derivatives transactions," he told the committee. "Improved transparency of swaps and security-based swaps enables regulators to monitor the exposure of counterparties to such OTC derivatives transactions, identify risk concentrations, and monitor systemic risks."

This mantra has been repeated so often that it now appears to be beyond challenge. However, while virtually all market participants are quite willing to agree that more transparency would be a good thing, there are now real concerns that the major pieces of regulatory machinery aimed at the OTC market - namely, the European Markets Infrastructure Regulation (EMIR), MiFID II and the US Dodd-Frank Act - might simply end up pushing risk elsewhere.

Market participants also point out that a very complex matrix of rules is emerging, particularly the rules regarding collateralisation, which are likely to elevate the cost of using derivatives to the point where market participants end up using inferior alternatives as hedges - or not hedging at all - thus increasing the amount of unwanted risk in the markets.

EMIR, which is under the aegis of the Financial Stability Board, sets out to increase stability within OTC derivative markets. The EMIR draft text sums things up succinctly: "The Regulation introduces: a reporting obligation for OTC derivatives; a clearing obligation for eligible OTC derivatives; measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives; common rules for CCPs and for trade repositories; and rules on the establishment of interoperability between CCPs."
In practice, however, the act of turning these laudable goals into actionable rules is generating a fog all of its own.

"No one really anticipated how complex this would be," says Ted Leveroni, head of derivatives at Omgeo. "If you look at the list of challenges and issues that the regulators are dealing with as they attempt to bring forward legislation, it's clearly growing exponentially."

One obvious instance is in the area of collateralisation. In the early days of EMIR, no one was talking about collateral liquidity issues, yet these issues are now huge and have arisen as part of the remorseless logic of the regulatory drive for ‘safety'. If you want to de-risk the swaps market, it seems logical to insist not just that trades are collateralised, but that the collateral is solid beyond doubt. You end up mandating ‘safe' sovereign debt such as US Treasuries, German Bunds or UK government bonds - or even cash. But in doing so you generate a huge problem that did not exist before: pension funds that use interest rate swaps and currency swaps to de-risk their liability and FX exposures tend not to have access to large piles of ready cash sitting on their balance sheets delivering paltry yields.

As a result, EMIR is likely to provide tremendous impetus to the collateral transformation market, creating good business for some, and a headache for others. Impeding pension funds from de-risking or fuelling a collateral transformation boom are presumably not consequences the regulators intended to bring about.

And it could get worse. Zohar Hod, global head of sales at SuperDerivatives, observes that not only will the new collateralisation rules incentivise market participants to seek out ever more baroque loopholes to avoid them; the fact that products too complex for central clearing will be excluded, as well as transactions in excess of $250m, will inevitably lead to simple products being made more complicated and the sell-side pushing clients into bigger deals. "So what have you achieved by standardising derivatives? Basically, you have incentivised the people who are dealing with derivatives to create very complex, very large products," says Hod. "None of this is what regulators intended."

EMIR initially provided a three-year exemption for pension funds, allowing them to continue to do bilateral swap trades without having to go through CCPs, to give funds time to develop solutions to this collateralisation problem. Jamie Lake, Principal Consultant with the capital markets consultancy Greyspark, points out that there is some flexibility with the exemption period as, given the scale of problems facing the funds, regulators appear to have adopted a "wait-and-see" approach to the implementation. However, he adds that the value of this exemption may well turn out to be near zero in practice.

"The US Commodities Futures Trading Commission (CFTC) are asking that every trade by a pension fund on which the fund wants an exemption is put forward individually," he says. "So they are going to have to generate all the paper work each and every time, on a trade-by-trade basis. Right now, pension funds are considered financial entities and, as such, they are ineligible for any future exemption from the clearing requirements anyway. Even if exemptions continue to be granted to pension funds, they may be more likely to seek alternative forms of hedging. rather than suffer the administrative burden".

Hod says that the regulatory costs that institutions, banks and brokers are going to have to meet under EMIR are enormous. "First you have to make a considerable expenditure to understand the regulations," he says. "Then there is additional cost of the transaction through increased collateral obligations and increased margin funding."

As many have pointed out, with different CCPs for different kinds of swaps (CDS swaps, interest rate swaps, and at a future date, some standardised FX swaps) it is not possible for a fund to net its margin as it would through a single broker. This is leading to a strong demand for tools that will enable buy-side institutions to do pre-trade analytics on what used to be a post-trade calculation.

"You have to decide which facility you are going to execute on, and who you are going to clear the trade with," says Hod. "You might have the London Clearing House (LCH) for FX, CME for interest rates swaps and the Intercontinental Exchange for credit swaps. We worked out that if you had 300 transactions, finding the most appropriate combination of platforms and clearers for that universe of 300 transactions, including working out how to place trades to incur the minimum possible margin, would involve working through as many as four million calculations. Tools to automate this are the only way to go."

Jonathan Bowler, business manager for Derivatives 360 at Bank of New York Mellon, argues that organisations and funds can still get some netting of collateral by putting as much as possible through the same CCP. However, he points out that funding initial margins on interest rate swaps is going to be steep, perhaps as much as 6% of the notional exposure. "Morgan Stanley has said that the industry is going to have to find over $2trn of assets to meet margin requirements," he comments.

These margin requirements did not exist in the bilateral world, of course, so it is very much a new burden. Moreover, deals that are not cleared through a CCP but remain bilateral trades will, under EMIR, still require either the buy-side or the seller to deposit an initial margin with a third party, and Bowler expects this margin to be very much greater than the margin required for cleared trades.

Then there is the cash requirement for mark-to-market variation margin. In a bilateral trade the two parties can decide that market movements below a certain threshold need not generate new margin calls. That won't be the case with CCPs. According to Bowler, JP Morgan is looking forward to providing collateral administration services to clients, including collateral transformation. "Everything has to be worked through on an individual basis with each existing client and new prospect, looking at the range of bilateral counterparties that they work with today and across which products," he says.
"Then you have to look at their available collateral and what needs to be done."

Raymond Haines, head of LDI at State Street says that while the principle of pushing OTC derivatives through CCPs to gain greater transparency is great, the devil is very much in the detail.

"If transparency was the problem, then all that was required was for the regulators to force people to post derivatives trades to a repository such as the DTCC," he argues. "What the rule makers did not take into account was that pension funds only have risk in one direction. They have no offsets with the centralised clearer such that an investing counterparty would have, which would enable them to net off positions against each other. So pension funds are going to have to post considerably more margin than they ever had to in the bilateral world. This means that the regulators end up disadvantaging the very people they are supposed to be trying to protect."

Haines points out, too, that while US pension funds have a viable alternative to interest rate and inflation swaps - long-dated Treasury futures, which are cheap and exchange-traded - in Europe, long-dated futures are completely illiquid.

"There is no long future in sterling, effectively and, in the euro, the long Bund future is not what you would call a liquid market," he says. It might be that as EMIR develops, the investment banks will look to make long futures more liquid by standing between buyers and sellers, and their incentive to do this will probably be that trading OTC swaps will become less profitable and more onerous.

"If this happens the big investment banks might put more capital into the futures market. That would be interesting and would give pension funds an alternative way of hedging risk," he concludes.

In the meantime, risk management is probably going to get a whole lot more expensive for Europe's pension funds, thanks to rules designed to curtail risks that have nothing at all to do with them.
 

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