Can standards deliver?

The road to hell is paved with good intentions. This expression may be too strong to be applied to the raft of over-the-counter derivatives market regulation being proposed, but there is certainly growing concern about the unintended consequences that may arise from these changes.

Regulators in the US are mulling over rules that would require all standardised OTC contracts to be traded on a designated contract market or registered alternative swap execution facility, and cleared through a central counterparty (CCP). Dealers and ‘major swap participants’ would have to hold additional capital for swaps not centrally cleared and report these trades to a central repository. The European Commission has proposed similar rules for the European Union.

Much of this has been welcomed by dealers, at least publicly. In fact, the industry has been working hard to facilitate central clearing of OTC contracts, fill gaps in market infrastructure and establish trade repositories. Some initiatives began even before the crisis, but have come under the watchful eye of the Federal Reserve Bank of New York and other regulators since the collapse of Lehman Brothers.

One of the major problems exposed by the crisis was regulators and dealers had no clarity on who was holding what risk. As a result, there was no clear idea what effect the collapse of one major counterparty would have on the financial system.

The setting up of central trade repositories, and stricter disclosure requirements, will presumably help solve this problem. But there has been a recent pushback on other parts of the regulations – in particular, the call for standardised contracts to be traded on a designated contract market and cleared through a CCP.

In recent months, major corporates have drawn attention to the fact that customised, bespoke OTC contracts have been used to hedge very specific and unique risks on their balance sheets. The use of standardised contracts is likely to leave them having to manage basis risk – and, in turn, unable to meet strict hedge accounting requirements. A change to the accounting rules may be necessary to offset this.

Trading on designated contract markets and central clearing will also require corporates to post initial and variation margin. For those with a shortage of cash, the collateral requirements could add further pressure in times of stress. Some have even claimed this could encourage them not to hedge their financial risks at all.

Some of this may be posturing, and both US and European regulators appear intent on pushing through the rules regardless. Nonetheless, the danger of rushing through sweeping regulatory changes means these and other unintended consequences may be overlooked.