By Joseph Neu
It’s one thing to write legislation on a topic that few understand, it’s another to make rules from it and it’s something else entirely to make it all work in practice. Efforts to reform OTC derivatives markets in line with Dodd-Frank mandates to push them toward central clearing are no exception. The closer regulators get to implementation, the more reliant they become on those who see to it that the markets actually work to determine the face and pace of their reforms.
A wake-up call to end-users
Derivatives end-users are waking up to this fact—and more should be heeding the alarm bells. The most recent sign that end-users are aware of the dangers of broker-dealers working discretely with regulators to guide derivatives reforms through their final stages comes in a letter sent by two corporate pension groups to the New York Fed.
“We are concerned about a secondary regulatory process that could undermine the public regulatory process,” wrote the pension trade groups (the American Benefits Council and the Committee on Investment of Employee Benefit Assets), in a letter obtained by Bloomberg News.
The letter specifically calls out meetings the New York Fed conducts with the OTC Derivatives Supervisors Group (ODSG). The ODSG originated in 2005, when the New York Fed hosted a meeting with representatives of major OTC derivatives market participants and their domestic and international supervisors to address inadequacies in market infrastructure for credit derivatives.
More recently, the ODSG has taken on the task of helping prudential regulators with implementation of the derivatives elements of Dodd-Frank, while also supporting the continued well-being of OTC markets. In a letter to primary regulators at the end of March, the group outlined its updated “roadmap” of initiatives and commitments in support of regulatory reforms being implemented in derivatives markets worldwide. These initiatives and commitments follow the guidelines set forth by the G-20, involving standardization of derivatives contracts, central clearing, bilateral risk management, and transparency. They also attempt to harmonize their market support, self-regulation and other goals with regulatory proposals.
Among other things, as noted in the New York Fed’s response, “the signatories to the letter have agreed to participate in a series of focused discussions with supervisors to resolve issues preventing viable central clearing options for clients (client clearing).” This, after the industry failed to meet its March 1 deadline to finalize plans for enabling clients to use central clearinghouses.
What the pension plan end-users are concerned about is what might be decided between regulators, dealers and other major market participants that they might not be happy with. Indeed, they and other end-user groups should have a seat at the table.
What could happen?
Perhaps the worst that could happen is that exempt end-users will see their exemption mooted in practice by outcomes from these working groups. This could be sparked by:
1) Regulators’ desire to see more derivatives clients and contracts pushed to clearinghouses. Such desire could result in onerous bilateral risk mitigation practices for uncleared trades, to include the obvious collateral or margin requirements, which they could make broker-dealers adhere to regardless of exempt status, or incent via capital and liquidity set-asides that are heavily biased toward cleared trades. Or, such desire could lead to implementation of less obvious bilateral trade disincentives via initiatives on valuation-dispute resolution or portfolio compression (net positioning)—again, designed to favor clearinghouses.
2) Broker-dealers desire to protect OTC margins. As the discussions within these working groups drag on, and progress with moving OTC trades to central clearing doesn’t proceed swiftly enough to satisfy regulators, at some point the sell-side might need to protect the continued existence of higher-margin OTC contracts by caving on bilateral risk mitigation.
Thus, the margin part of the end-user exemption, at least, continues to be at risk. And end-users’ efforts to protect it must now shift from the CFTC (and SEC) to the prudential regulators, including the back-and-forth that is taking place within the ODSG and related implementation working groups.