OTC, Central Clearing or Exchange-Traded: Choosing the Right Path
Regulation is a funny thing. It's the lanes on the road, the squares on a chessboard and the rents in Monopoly -- the more you drive or play, the more the rules fade into the background and you focus on strategy (How do I get there? How aggressive should I be? Which properties should I buy?). Similarly, regulation hides in plain sight and becomes the table stakes underpinning your business strategy.
The over-the-counter (OTC) business is a lot like that: Regulations have been set, the world trades the way it does and most folks don't think twice. Bonds, asset-backed securities, currencies and a large portion of derivatives have always been traded over the counter, and they will always be traded over the counter. End of story. Trading desks, operations, technologies, financing and capital for these products have been structured around an OTC market, and they can't change -- can they?
With the subprime challenges, it became clear that the OTC markets had to change, especially for credit default swaps (CDSs). These complex products lacked transparency, challenged operations, and were under fire from legislators and regulators. But how do you migrate an OTC market to a central clearing model or onto an exchange? How do you centrally clear -- or, for that matter, exchange-trade -- very large and customized products that few people understand, have little liquidity and are very profitable for dealers to trade through the current OTC mechanisms? Do you mandate it? And even if you do mandate it, will dealers, issuers and investors come?
Before the subprime crisis I couldn't understand why dealers would ever give up the goose that laid the golden egg and migrate OTC products to centrally cleared or exchange-traded mechanisms. After the subprime mess, however, I reversed my opinion and was sure that investors would push dealers to migrate these products away from banks' balance sheets. Looking at the market now, I realize my initial thoughts were more accurate. OTC products are alive and well, and with their very steep yield curve (low short-term rates -- effectively zero -- and high long-term rates), dealers are raking in profits hand over fist. Why would they support moving these products to exchanges and thus cratering their business model?
Capital Motivation
I recently had a discussion with Walter Lukken, the acting chair of the Commodity Futures Trading Commission (CFTC), and the answer became obvious: capital. Banks hold reserves based on the assets they own. This capital is held in reserve in case the assets become nonperforming or impaired. Altering capital reserves changes the profitability and profiles of the products that banks hold and issue. Regulators only need to implement a sliding capital scale depending on the product, clearing method or trading mechanics to change the way that products are developed, underwritten, traded and positioned. Naturally exchange-traded products would have the lowest capital requirements, centrally cleared products a bit higher and OTC self-cleared products would maintain the highest tariff.
Now, just changing reserve requirements does not directly change how products are issued and traded. But it does change their economics. And it is economics that will force firms to discontinue, centrally clear, or develop a new and more fungible CDS product that could be more easily priced, cleared and exchange-traded.
While adjusting capital requirements is a great lever for change, modifying capital charges is not as easy as just issuing a white paper. Look at how long it took to pass and implement Basel II. Just the thought of obtaining global regulatory and banking consensus, as well as aligning the business, operations and technology, makes my head swim. If we really want to mitigate risk, however, simple mandates may not work, and we should think about capital as both the carrot and the stick to get the market to adequately regulate and manage risk.
While the majority of us move around the board looking for opportunity, sometimes the best way to change the landscape is not by developing a new strategy, but simply by changing the board. And when you are the regulator, that isn't on the list of impossibilities.
Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio
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