September 20, 2013

At the Sibos conference in Dubai, a vocal critic opened fire on Dodd-Frank regulations calling for central clearing of OTC derivatives. Collecting data on individual deals won't yield a clear picture of the aggregate markets, he said, and it's a huge cost to the industry and its clients.

Throughout a panel discussion on securities regulation, John Wilson, Global Head of OTC Clearing at Newedge, listed a litany of reasons why mandatory central clearing for OTC derivatives is misguided, ill-executed and damaging to the health of the financial system. Newedge is a joint venture between Société Générale and Crédit Agricole CIB that specializes in execution and clearing of futures and options trades.

Wilson sees mandatory central clearing of OTC derivatives as a tax on the financial system, the cost of which will be borne ultimately by pension funds and other investors.

The question of what makes acceptable collateral to a trade has become the source of much anxiety and uncertainty in the industry. The new clearing rules have sparked a shortage of the easiest-to-value collateral, such as the safest government bonds, and the acceptability of other collateral has been subject to inconsistent treatment across CCPs, such that a portfolio of equities may be rejected at one CCP but accepted at another. "If you have the 'wrong' assets, you have transformation costs involved," said Wilson.

To avoid those transformation costs, some trading firms may shy away entirely from the relatively strict requirements of Dodd-Frank by not entering into OTC derivatives contracts with U.S.-based counterparties.

While this may provide temporary advantages for non-U.S. banks that capture the other sides of those trades, the overall market may suffer from a reduced number of counterparties and diminished value of cross-border trade. "Those barriers increasingly concern me," said Wilson.

Wilson is also concerned -- and frustrated -- by the whole concept of regulators attempting to manage systemic market risk by gathering data on individual trades. "It's kind of pointless," he said. "A [bank's] risk officer never asks to see a trader's daybook. They ask to see their risk positions, their VaR [Value-at-Risk]."

Consequently, Wilson calls "nonsense" on "the idea that [regulators] can take in all this data and make sense of it [when] they still can't find the JPMorgan 'London Whale' trades."

On The Other Hand

Not everyone was down on CCPs. In a later session, Larry Thompson, managing director and general counsel at DTCC, which runs a CCP of its own, commented on the expected benefits of CCPs.

One benefit: if trading firms can offload the risk that a counterparty may fail prior to settlement, it may enter into more contracts, thus increasing the size of the overall market. "Putting more asset classes into CCPs ... may increase competition by lowering the cost of barriers to entry," said Thompson.

CCPs should also reduce systemic risk, as per the regulators' desires. "A well-run infrastructure should be reducing systemic risk – that's a CCP's job," said Thompson. "As long as it's well regulated, has market standards enforced, and agreed practices, it should be able to mitigate the risk to the marketplace."

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For reducing systemic risks to the financial markets, the key driver is transparency, explained Thompson. "Transparency drivers all of the other issues," he said. "If you have transparent markets, your CCPs are going to work better, your CSDs [Central Securities Depositories] are going to be more efficient, and in terms of operational risk capabilities, you'll be able to cut costs more significantly."

Nevertheless, as to whether CCPs are adequately capitalized, that's "an open question," remarked Thompson. "When it comes to the issue of the newer CCPs and OTC derivatives ... we don't know their liquidity in a market close-out [situation]."

In the comments -- So, what concerns you more: the specter of a recurrence of 2007, when the failure of over-aggressive trading firms sparked a global financial crisis, or the fear that the regulations are going too far in a direction that's doing not enough to prevent the next global financial crisis?

Will regulators be able to build an effective early-warning system based on the transaction-level data they're trying to collect, or will they be trying to count the raindrops during a hurricane?