The future of derivatives in a new regulatory world
April 09, 2014
Prior to the financial crisis that slammed capital markets in 2008, the notional value of financial derivatives increased at a spectacular pace. This kind of growth may resume once users understand the market's ongoing transformation resulting from the Dodd-Frank legislation passed by Congress in 2010. By the same token, it's possible that derivatives trading will migrate to exchanges as the advantages become more apparent and regulation reduces the flexibility of OTC operations. This could prove to be the best of all possible worlds, as exchange trading will adequately meet business demand for risk management without the systemic risk of the over-the-counter environment.

It is premature to predict that rosy scenario, however. Industry experts project that 60 percent or more of former OTC derivatives volume will be centrally cleared. The actual percentage will depend in part on how banks, as liquidity providers in the OTC model, rethink product distribution to clients. Yet bankers are warning that as clearinghouse-based swaps trading expands, counterparty risk will actually increase because the clearinghouses lack adequate capital aEUR" a worry, by the way, that their executives vehemently dispute.

In addition, given the relatively low transaction volume in swaps, it is not clear that most swap traders will be motivated to invest in the technology-based innovation required to participate in these markets going forward. The role of broker-dealers will increasingly shift from principal to agency trading, enabling connectivity and access to liquidity in a multichannel landscape of trading venues, including the swap execution facilities (SEFs) and organized trading facilities (OTFs) required by U.S. and European Union regulations. This is expected to contribute to lower revenue in the broker-dealer community as evidenced by JPMorgan ChaseaEUR(TM)s recent disclosure that its derivatives-related revenue could drop by $1 billion this year.

Another issue that will be crucial for derivatives in the new regulatory world is the requirements for collateral. Prior to Dodd-Frank, the lack of regulated margin (collateral) requirements propelled the growth of the market in swaps. The imposition of such requirements on both cleared and uncleared swaps will have a noticeable impact on the cost of hedging. Collateral requirements could run as high as $10 trillion and, according to industry sources, the total margin shortfall under the new market structure could range from $800 billion to more than $2.5 trillion. However, although these estimates appear large, advances in risk management methods are likely to dampen their impact.

It remains to be seen whether the cost of meeting margin requirements will spur the migration of OTC derivatives activity to exchanges. Whatever the outcome, there is little doubt that a great deal of exotic derivatives activity will cease in the face of these constraints and the additional charges likely to be imposed by clearinghouses on less-liquid bilateral trades. According to a study by the Tabb Group, more than $130 trillion in derivatives' notional value might not be clearable.

With regulation determining much of the dramatic restructuring of the OTC derivatives market, the potential need for further fine-tuning or even more radical alterations of the rules cannot be dismissed. Looking at the history of financial markets, whether the focus is equities, bonds, commodities or futures, it's clear that market participants have been the drivers of trading efficiency. While regulators have generally kept a watchful eye on developments, they have been reticent to mandate trading of a product on a particular market. The orchestration of such activity now could indeed lead to unintended consequences.

If the logic of exchange trading as set forth in Dodd-Frank is to bring transactions into public view, then why would trades with non-financial corporations or large block tradesaEUR"which are exempt under the lawaEUR"not benefit from the same transparency? We shall see how events unfold.