OTC shake-up likely as regulators mull centralised clearing

US legislators are pressing for reforms that will lead to a big shake-up in how over-the-counter derivatives are bought and sold. The question is how this will affect the structured notes market. John Ferry reports

The outlook is uncertain for OTC derivatives

With President Barack Obama’s healthcare bill finally passed, financial regulatory reform in the US is likely to move back up the political agenda in coming months. A major part of the reform effort focuses on over-the-counter derivatives, with a number of bills being debated by Congress that aim to formalise oversight and move a big chunk of the market onto exchanges. The plethora of bills that have come out make it difficult to foresee what the likely impact of final legislation will be, but derivatives experts and issuers are already warning that the proposals look likely to have an impact on issuers of structured products.

Legislators want to shift ‘standardised’ OTC derivatives trades onto exchanges, while also requiring that the contracts be processed through clearing houses. “With so much moving onto exchanges there could potentially be less innovation. I’m not sure we will have as much freedom as we have right now to put new structures in place and trade them right away,” says Fabrice Hugon, head of the structured solutions group at BNP Paribas in New York.

Hugon says it is too early to plan for the outcome of the legislative changes, but he feels sure those changes will affect his business. “It is very unclear for now what’s going to happen, but it’s definitely going to change the picture for the structured products market,” he says.

Anna Pinedo, New York-based partner and structured products specialist at law firm Morrison & Foerster, says the impact on hedging could be significant. “Many in the industry are surmising that hedging costs will go up generally while availability will go down,” she says.

Some, however, feel the impact on the structured products market will probably be marginal at best. Ray Shirazi, New York-based principal partner in law firm Cadwalader’s structured products practice, takes this position. “There are two ends to this business: the front end, which is the issuing process, and the back end, which is the hedging process. As far as the front end is concerned there is no change,” he says. “In terms of hedging, for anyone hedging in cash markets, anyone hedging using listed options or unlisted options, as well as those hedging using listed futures, there is no change. The only change is for those people hedging now in some sort of swap format. They are going to be forced onto some sort of centralised clearing party and will be subject to new margin requirements set by the clearing organisation. So that’s only one out of five hedging possibilities where this will have an impact.”

One step at a time

Regulatory reform was first proposed in May last year when US Treasury Secretary Timothy Geithner wrote to Congress outlining comprehensive regulatory reform of all OTC derivatives markets. The following month, the Obama administration released its recommendations for reform of the system, echoing many of Geithner’s proposals.

Then came Senate Banking Committee chairman Chris Dodd’s reform proposals – in the form of a discussion draft – in November, which proposed that the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) be given authority to regulate OTC derivatives so that “irresponsible practices and irresponsible risk-taking can no longer escape regulatory oversight”. It also proposed central clearing and exchange trading for derivatives that “can be cleared” and a role for both regulators and clearing houses to determine which contracts should be cleared, with the SEC and the CFTC pre-approving contracts before clearing houses can clear them. Further, it proposed that traders be required to post margin and capital on uncleared trades so as to “offset the greater risk they pose to the financial system and encourage more trading to take place in transparent, regulated markets”. A final proposed requirement was for trade data to be collected and published through clearing houses or swap repositories, with the aim of improving market transparency and giving regulators a way to monitor and respond to risks in the system.

The next significant development was the passing of the Wall St Reform and Consumer Protection Act of 2009 by the House of Representatives, which requires that clearable swaps be traded on an exchange or swap execution facility while exempting end-users that use swaps to hedge commercial risks. Then came Dodd’s March bill, which largely tracks the Senator’s previous financial reform package.

Pinedo says clarity on the final form of legislative changes should emerge this summer. In the meantime, issuers are left to guess what the impact on their businesses will be. So what is the case for the final rules having a significant effect on hedging? Pinedo says increased costs will emerge not just because of the move to centralised clearing. “Hedging costs will go up because more retained swaps will be moved to central clearing, which requires more margin, but also because of another provision in the legislation – section 23A – which affects transactions between affiliates, limiting the aggregate exposures between an issuer and its broker-dealer affiliates,” she says.

The March Dodd Bill proposed changes to “Section 23A” of the Federal Reserve Act, which limits the aggregate amount of certain transactions a bank can do with a single broker-dealer. The Act stipulates that “covered transactions” between a bank and a broker-dealer have to, in aggregate, amount to less than 10% of the “capital stock and surplus” of the bank, and be less than 20% of the capital stock and surplus for all transactions done with broker-dealers in aggregate.

In non-legal terms, that means, according to Pinedo, that issuers will have to split their business between different broker-dealers in a way they never had to before, which will make hedging more expensive. “Right now in the structured products market, an issuer issues a note and its broker-dealer affiliate then writes the swap. But if 23A goes forward as expected then the affiliate will not be able to do the swap for the affiliated issuer, which means they’ll have to move to a third-party provider, and that third-party provider is likely going to be more expensive,” she says.

Pinedo says changes to Section 23A, the move to centralised clearing and broader regulatory changes to the banking system will combine to affect how structured products are priced and constructed. “It’s a threefold effect,” she says. “The leverage is being sucked out of the system through a series of banking laws and Basel III-type initiatives. The margining requirements are going to go up, and then there will be more limitations on pools the issuer can enter into the hedge with. The combination of those three things is, I think, going to affect the economics.”

Is the expectation of change affecting the structured products industry? Are dealers already altering their hedging strategies in the expectation of a more onerous swaps market appearing? “For now, it’s business as usual,” says Hugon. “I think the picture will change once the legislation has been passed and people know what the rules of the game are.”

One thing is for certain. Legislators and regulators are determined to see derivatives markets subject to unprecedented levels of reform. Speaking at a derivatives market conference in New York on March 9, CFTC Chairman Gary Gensler reiterated regulatory determination to put in place a framework governing OTC derivatives that would apply to “all dealers and all derivatives, no matter where traded or marketed… It should include interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future,” he said.

By pushing ‘standard’ OTC derivatives into clearing houses, transactions with counterparties can be moved off the books of financial institutions that may have become too big or too interconnected to fail, said Gensler.

There are subtle differences in the numerous bills that have been introduced to get the ball rolling on reform, but key to the impact of final changes will be the definition of a ‘standard’ derivative, and the exemptions that will be included in the legislation.

Under Dodd’s bills, this amounts to a definition of a swap that excludes, among other things, foreign exchange swaps and forwards – unless otherwise determined by the CFTC and the Treasury – and sales of non-financial commodities for deferred shipment or delivery that are intended to be physically settled. It also includes “security-based swaps”, which are swaps primarily based on some form of security.

As the various pieces of legislation make their way through Congress there will be plenty of scope for these sorts of details to be changed. The banking industry will be pushing for the final legislation to be watered down, while the politicians will have a vested interest in at least appearing to be tough and reform-minded. And while the final impact on the structured products market may be open to debate, the mood for change is not.

Legislative maze

A number of legislative proposals could potentially impact the OTC derivatives markets. The following is a summary of legislation so far proposed or passed.

In December, the House of Representatives passed the Wall Street Reform and Consumer Protection Act, which requires clearable swaps be traded on an exchange or a swap execution facility. However, it exempts end users that use swaps to hedge commercial risks. The Act limits aggregate clearinghouse ownership among swaps dealers to 20%, and gives regulators the power to require all swaps dealers and major swap participants to register with the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC).

Also in 2009, Collin Peterson, the House of Representatives Agriculture Committee chairman introduced legislation that would enact mandatory central clearing of OTC derivatives and suspend naked credit-default swap trading, while the American Clean Energy and Security Act, which was introduced by Henry Waxman, Energy and Commerce Committee chairman and Ed Markey, a Republican also includes provisions that restrict the trading of OTC energy derivatives. In October, Barney Frank, House Financial Services Committee chairman and Peterson drafted and marked up two different versions of bills that require clearing of eligible derivatives transactions, and also that those transactions originate on regulated exchanges. According to the Securities Industry and Financial Markets Association, the bills differ on key definitions and other provisions, including exemptive authority granted to primary regulators.

In the Senate, Tom Harkin, Agriculture Committee chairman, introduced legislation that would move most OTC derivatives onto CFTC-regulated exchanges, while other bills concerned with derivatives regulation have been introduced by Senators Carl Levin, Susan Collins and Ben Nelson. In September, Senator Jack Reed introduced the Comprehensive Derivatives Regulation Act, which stipulates that standardised derivatives transactions should be cleared, although it does not mandate exchange trading for cleared transactions. However, it does require all OTC transactions be reported to trade repositories, while not calling for shared regulatory jurisdiction between the SEC and the CFTC. In November, the Restoring American Financial Stability Act emerged from Chris Dodd, Senate Banking Committee chairman, establishing a presumption of clearing for derivatives transactions. The bill also mandated exchange trading for cleared transactions, while granting the SEC and CFTC limited authority to exempt transactions from clearing requirements. On March 15, Senator Dodd released the Restoring Financial Stability Act of 2010.