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OTC Derivatives Industry underprepared for impending regulations

By Ganesh Iyer, Senior Product Marketing Manager for Network Services at IPC Systems

Ganesh-IyerThe year 2013 will see many of the financial reforms, which have been long debated, drafted and legislated in recent years, come into effect. The regulations which will most impact the trading industry are Dodd Frank and European Market Infrastructure Regulation (EMIR).

The regulations have been formulated to improve transparency and reduce the high levels of risk associated with the OTC derivatives industry. Regulation of OTC derivatives trading has been a foregone conclusion for the last few years but just how prepared is the industry for the regulations? IPC recently conducted a survey among hedge funds, investment banks, broker/dealers, exchanges and other financial institutions asking this question, as well as exploring their perceptions of the impending regulations. The responses revealed that financial institutions are underprepared to meet the requirements these regulations will place on them, even as they plan to increase their trading activity in OTC derivatives.

Trading in OTC derivatives has seen huge growth in recent years. The survey found that 94 percent of firms are already trading swaps or other OTC derivatives or plan to do so in the next six months. However, only 19 percent said the industry as a whole was well prepared to meet the regulations. This is perhaps surprising given that 74 percent of respondents said they expected their firms’ trading volumes to increase in the next year. These results confirm what we have been hearing from the market and it raises serious concerns that neither individual firms nor the industry as a whole are well-prepared for the coming changes.

An area of industry debate has centred on whether the regulations will reduce risk as they are intended to. Despite a major driver for these reforms being to reduce systemic risk, only 29 percent of respondents believed that the reforms will actually result in reduced risk. However, 57 percent believe that increased market and transaction transparency will be a major benefit resulting from the new regulations. The increased availability of market data is also recognised as an important benefit of the reforms. Worryingly, 21 percent of respondents felt that there could be consequences for the future of OTC derivatives trading as a result of what they perceive to be ill-conceived rules which have not taken into consideration all elements of risk.

Key findings from IPC’s OTC Derivatives Trading Trends Survey

Trading to grow significantly

  • 94 percent said their firms are already trading swaps or other OTC derivatives or plan to do so in the next six months;
  • 74 percent expect their firms’ trading volumes to increase in the next year.

Lack of regulatory preparedness

  • 36 percent reported that their company did not have a plan in place to deal with new regulations;
  • 62 percent said their firms were not well-prepared for the impending regulations;
  • Only 19 percent said the industry as a whole was well prepared to meet the regulations.

Mixed views on benefits of regulations

  • 26 percent say the benefits of new regulation far outweigh any associated costs;
  • 31 percent say the impact of new regulation will be negative leading to increases in the cost/complexity of trading with little or no benefits.

Increased transparency; reduced risk

  • 57 percent expect new regulations to increase market and transaction transparency and 53 percent cited this benefit as moderately or critically important;
  • 43 percent said that reducing systematic risk was moderately or critically important but only 29 percent expected new regulations to actually reduce such risk.

View of the future

  • 66 percent expect to see trading shift to the futures market;
  • 19 expect the importance and value of the OTC Derivatives market to grow.

It’s all about connections

  • 62 percent say their firms are or will be connected to one or more SEFs;
  • 39 percent are connected or plan to connect to more than 10 SEFs;
  • 23 percent will connect to more than 20 SEFs.

The establishment of Swap Execution Facilities (SEFs) is a pivotal aspect of the regulations in the US. Dodd Frank defined SEFs as “a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce.”

For trading firms, connectivity to SEFs will be critical not only for addressing compliance concerns but also for gaining competitive advantage and capitalising on new opportunities. Some of the industry appears to recognise this as 39 percent of respondents said that their firm is connected or planning to connect with 10 SEFs or more, and 23 percent revealed plans to connect to over 20 SEFs. However, 34 percent of firms still did not have a plan in place to connect to any SEFs.

Some have argued that the upheaval in the OTC derivatives market will drive traders towards the futures market, using new swap futures contracts which offer easier access to similar exposures and at a lower cost. While 66 percent of respondents are expecting to see a shift to the futures market, it is important to recognise that swaps were created with a specific purpose in mind. It seems more likely that the two markets will coexist, but with some swaps becoming futurised, although not every swap has an economically equivalent future. Currently swap futures do not have the liquidity or investor confidence to really challenge swaps at the moment.
The respondents to the survey came from both buyside and sellside firms and covered a broad range of roles supporting the full trade lifecycle from order initiation and execution to clearing and settlement. Respondents came from the front, middle, and back office and included people involved in both the business and technology sides of trading operations.

There is still a great deal of uncertainty and lack of clarity around these regulations which understandably has resulted in institutions delaying their planning. As yet trading firms do not have a clear picture of what they need to do to implement and comply with these regulations. Originally the market expected clarification from the regulators by the end of last year. The delays mean that 2013 is the year when these issues will be resolved and the industry should receive the clarity and direction needed to allow them to implement systems to manage and comply with OTC derivatives regulations.