For months, it has been clear that the Credit Default Swap market is in for a serious shakeup (also, equity swaps). But when the proposed changes to derivative regulations were issued by Treasury in mid-May, they were far reaching, scoping in ALL derivatives and focusing on reconfiguring the current mechanics of the over-the-counter (OTC) market in other to provide greater price and risk transparency.
In a letter to Senator Harry Reid on May 13, the Secretary of the Treasury proposed a sweeping regulatory change to the current “operations” of the OTC derivative market. Secretary Tim Geithner’s proposal (to be followed by a more detailed piece of legislation) appears to cover any OTC derivatives; it even specifically mentions swaps as an example of a derivative that would be affected by the change.
The letter lays out the Administration’s main objectives:
(1) Take all standardized OTC product off the OTC market and onto centralized clearing facilities or the exchanges, thus reorganizing the “holders” of risk and the perception of counterparty credit risk.
(2) Promote efficiency and transparency;
(3) Prevent market manipulation and
(4) Ensuring the OTC products are not marketed to less sophisticated end users.
How will this affect corporate end users?
It’s early days and until a more complete version of the proposal is delivered to Congress it will be hard to figure out how the new rules would impact corporate end users. Treasury’s objective of greater price transparency may indeed work in corporate end-users’ favor, as prices are often opaque. Exchanges also stand to benefit from a likely increase in traffic.
The proposed bill itself, written in broad strokes only to date, does not contemplate the effect of these changes on companies and other end users. It focuses on the banking community. “We believe that for any proposal to require mandatory clearing of OTC derivatives … must set forth clear objective criteria to determine whether an OTC derivative is standardized,” according to Ross Pazzol, a partner with Chicago law firm Katten Munchins Rosenman LLP. He goes on to note that a mechanism must be in place to prevent banks from “artificially” tweaking what is a standard derivative into a non-standard one simply to avoid clearing mechanisms.
So while the effects may be very far reaching, or relatively contained, here are a few areas that may well by impacted by the legislation:
1. Cost. The transparency and central clearing of derivative trades will dramatically change banks’ business models, which often rely on OTC trades for a fat margin. Indeed, banks often rely on profit from derivatives trading with corporate clients to support less-rewarding or even money-losing business lines. With the margins gone, banks will likely have an incentive to generate new income, perhaps through fees they’d charge their clients in order to clear trades on their behalf. Alternatively, companies would be able to set up a standing direct relationship with a clearing firm; however, that sort of relationship would undoubtedly come along with a margin or some credit enhancement guarantee. Either way, the cost of derivatives trading will be clear for all to see, likely producing a relatively larger benefit for small and midsize companies that do not share the clout of their large multinational brethren.
2. Standard or not. Companies will also have to figure out, once the definition of standard becomes clearer, whether they prefer the relatively cheaper clearing house “standard” version or rather pay extra for “designer” derivatives that perhaps more perfectly match their needs; the potential discrepancy in timing or notional amount – along with margin calls – has always been a stumbling block for corporate taking advantage of the nonperformance-risk free exchanges. And if companies prefer designer version, those will come with a higher price tag, too, as the banks would have to disclose their position and put up more capital against them.
Will the new rules be a game changer? First off, the suggested changes are in early stages and already, some of the related market regulations, e.g., the plan to merge the SEC with the CFTC is on the rocks. Second, whether the changes make a fundamental difference also will depend on the sort of organization in question. Clearly, large banks will have to make substantial changes to their business model and/or their pricing. But for companies, which make up a much smaller share of derivative activity, the changes may not be as dramatic.
“I think the short answer is that an end user would not necessarily have to trade on an exchange if there is mandatory clearing for standardized OTC derivatives,” ‘writes Mr. Pazzol in an email to Hedge Trackers. “For example, an end user can do a trade in the OTC market today and submit it to NYMEX Clearport for clearing. However, if mandatory clearing comes about, end users would have to either become members of the relevant clearinghouse or establish a clearing relationship with someone who is such a member.” This changes the credit risk inherent in these transactions, because if you clear trades through someone else, you are exposed to their credit risk, not the credit risk of your original counterparty.