Isda AGM: ‘Life as we know it will change,’ says O’Connor

New regulations will help reduce systemic risk, but changes need to be made to certain parts of the rules, Isda chairman says

Regulatory changes will fundamentally change how the derivatives markets work, but some of those changes could harm the global banking system, according to Stephen O'Connor, managing director and global head of over-the-counter client clearing at Morgan Stanley and chairman of the International Swaps and Derivatives Association.

Speaking at Isda's annual general meeting in Chicago this morning, O'Connor stressed the derivatives industry supports regulatory efforts to reduce systemic risk, but argued that some of the proposed rules could have a negative impact on liquidity.

"Life as we know it will change. Consider that in the next 12 months, some trades will be reported to the public on a real-time basis, bilateral margin requirements will be required by law, and it will be illegal to execute certain transactions over the telephone," said O'Connor. "We need to be ready for this new world and we need to understand what it all means. We need to support and adopt those things that do make sense – and we need to try and change those things that don't."

One of the biggest problems is the inconsistency between different national regulations. In particular, he pointed to the possible extraterritorial application of the Dodd-Frank Act – and claimed this could put US financial institutions at a competitive disadvantage. It could also create problems for foreign firms that have US operations - those entities may have to comply with aspects of Dodd-Frank, alongside their own, potentially contradictory national rules.

"Disadvantaging foreign institutions and their US subsidiaries through divergent capital requirements, or otherwise, discourages foreign investment in US subsidiaries, which will have negative consequences for the broader economy. Such divergent treatment also creates the potential for retaliatory measures between jurisdictions, further reducing liquidity and competitiveness and creating fertile ground for regulatory arbitrage," he said.

"Extraterritoriality is a very real concern. Steps must be taken now to ensure these concerns are properly resolved. Failure to address these issues promptly will have a real and direct impact on the global banking system and the global economy."

Differences in clearing rules in individual jurisdictions could also cause problems, he said. Some domestic regulators, including those of Hong Kong and Canada, have proposed making it mandatory to clear certain local currency derivatives transactions onshore – requirements that could lead to a proliferation of domestic central counterparties (CCPs). This could lead to a fragmentation of liquidity and break-up of netting sets, which would eliminate efficiencies and lead to higher costs for end-users, O'Connor argued.

"Isda strongly supports clearing requirements, but wants to ensure the implementation is done right. Clearing houses must be able to survive market stress events and rigorous stress tests. They must be able to continue operating after member defaults. We don't want to see a race to the bottom on margin terms, nor a fragmented market caused by a proliferation of CCPs, which is a real risk due to inconsistencies in global regulation," he said.

"Any trend towards a weak, fragmented clearing system will result in a market less secure than exists today."

O'Connor also highlighted concerns around amendments to market structure – changes he claimed could hurt market liquidity without providing any tangible benefits.

As an example, he pointed to rules in the US and Europe that require certain OTC derivatives to be executed on electronic platforms. Regulators hope these rules will foster greater transparency and competition in derivatives markets, but O'Connor claimed this already exists, with several screen-based pricing systems already operating. Citing cost-benefit analysis conducted by Isda and Nera Economic Consulting last November, which estimated initial set-up costs of more than $750 million and annual costs of $250 million, he argued these requirements would actually lead to wider bid-offer spreads and higher costs for end-users.

"There may be marginally better transparency of pricing for a small group of users once the mandate comes into effect, but at a cost of making the market inefficient and more expensive for everyone else," he said.