IQ Which regulatory changes are likely to have the biggest impact on market participants in 2016?
Keith Bailey, managing director, market structure, Barclays
The EMIR clearing mandate requires market participants to clear certain trades on European Securities and Markets Authority authorised (EU) or recognised (non-EU) CCPs, with the first category phase-in starting on June 21, 2016. This includes trades executed after February 21. Although the capital costs incurred by certain EU firms for clearing via non-qualifying CCPs continue to be deferred, June 21, 2016 represents a firm date by which equivalence (a prerequisite for non-EU CCP recognition) must be granted. Without equivalence, all EU/US clearing will have to migrate exclusively to dually registered CCPs when required to comply with both the Dodd-Frank Act and EMIR.
The regulatory efforts to adopt equivalence assessments have been commendable, but the time taken over this process for CCPs raises concerns about similar evaluations needed for eligible venues, in order to allow the derivatives execution mandate to be satisfied across multiple jurisdictions.
Granting an equivalence determination between US SEFs and EU multilateral trading facilities/organised trading facilities should be fairly straightforward. Many of the G-20 policy objectives for introducing a trading mandate – impartial access, conflicts management and operational certainty, for example – have direct parallels in both rule sets. And while it is true that the approach to enhancing transparency is slightly different, both address this issue. Ultimately, the measure of whether the regimes are equivalent on an outcomes basis is reflected by whether the market moves with its feet one way or the other following an equivalence determination. We believe these regimes are sufficiently similar that there is no basis on which to think this will occur.
“Although the capital costs incurred by certain EU firms for clearing via non-qualifying CCPs continue to be deferred, June 21, 2016 represents a firm date by which equivalence (a prerequisite for non-EU CCP recognition) must be granted”
Steven Lofchie, partner, Cadwalader, Wickersham & Taft
We are sufficiently distant from the financial crisis that we should be able to evaluate our response and not just produce new rules. But that’s not really happening. At best, the rate of regulatory increase has slowed – and that’s an optimistic take. We may just be so exhausted by the rate of change that we have lost the ability to perceive it.
So, what lies ahead? The US Securities and Exchange Commission (SEC) will come out with a comprehensive set of requirements for security based swap dealers, and will set a deadline for such entities to register. Both the Commodity Futures Trading Commission (CFTC) and the SEC will adopt capital regulations for swap entities, but the biggest capital issue will be leverage capital requirements from US banking regulators. These require banking organisations to hold capital against collateral posted by customers on swaps and held in segregated accounts. This provision is sufficiently burdensome that it has been the subject of opposition even by the CFTC chairman.
Elsewhere, the SEC is working on new liquidity requirements, which will hit the largest firms the hardest. When these rules are adopted, they will impose a further drag on firms serving customers. The SEC will also adopt margin requirements for non-cleared derivatives following the CFTC and prudential regulators, which issued their final rules at the end of 2015. The big questions are: will the SEC (1) mandate two-way margining; and (2) permit the holding of customer collateral in tri-party accounts.
Meanwhile, the systemic risks of central clearing are being recognised by regulators. While clearing-house failure gets the most attention, it may actually be a less of a risk than increased interconnectedness, exacerbation of too big to fail, and the potential for clearing houses to suck liquidity from the system in a market downturn. Expect the expansion of mandatory clearing to be put on hold.
A new challenge will be the continuing transformation of operations and technology into regulated areas. Sufficient safeguards on operational change will become legal requirements. The big risk will be that any operational failure will be deemed a legal violation.
Darcy Bradbury, managing director of DE Shaw & Co, director of external affairs, DE Shaw Group
There are generally two kinds of regulations: those that change how we invest, which are most important, and those that drive up the cost and complexity of compliance. In the first category, we are focused on rules that will dictate margin for non-cleared swaps. The funds we manage have always had to post initial margin on such swaps, unlike some other end users. But the new rules being considered by regulators across the globe could change both the amount of margin, as well as the ability to net margin requirements across portfolios when there are offsetting exposures. In addition, the requirement for banks to post initial margin to our funds for non-cleared swaps, if exposures are large enough, may indirectly increase costs and inadvertently limit access to certain counterparties.
“We are focused on rules that will dictate margin for non-cleared swaps”
There are also investment-related rules that could impact our counterparty credit exposure, including SEC and bank capital requirements relating to arrangements where our initial margin is held in third-party custody. In addition, new rules from bank regulators would reduce our protection in cases of bankruptcy and/or resolution of systemically important banks. The rules would impose temporary stays if a counterparty fails, eliminating our current close-out netting rights, which would diminish our protection.
Finally, we continue to believe that impartial access for investors to trade on all SEFs could be enhanced. On the compliance side, there are a wide range of new transaction and reporting rules, especially in the EU, which will require investment firms to create systems for daily reporting of a wide range of transactions and holdings, including swaps and other derivatives. This will be costly and complex, and will also pose cybersecurity risks as more proprietary information is transmitted to multiple parties around the globe.
Diane Genova, general counsel, corporate and regulatory law, JPMorgan Chase & Co
The mandatory margin requirements on non-cleared derivatives will have a significant impact on the derivatives market in 2016 and beyond. The US, EU and Japan have already proposed or finalised non-cleared derivatives margin rules, which will become effective from September 2016. Because the substance of the rules and the implementation timelines are coordinated between regulators in different jurisdictions (a first among the regulations coming out of the G-20 derivatives market reform commitments), the impact of the rules could be felt globally on a ‘big bang’ basis.
The non-cleared derivatives margin rules will generally require market participants to re-document their existing credit support arrangements and use approved models to calculate initial margin (IM). Market participants will have to exchange IM on a gross basis and to segregate that IM at a third-party custodian, where it cannot be rehypothecated or reused. A quantitative impact study on the proposed rules published by the Basel Committee and IOSCO in 2013 indicated that the amount of required IM market-wide would be about €600 billion. Given the magnitude of the requirements, many market participants will need to make substantial investments in their collateral infrastructure and change the way they manage collateral. It is also notable that inter-affiliate transactions will need to be collateralised in the same way as external trades under the margin rules of some jurisdictions.
Although national margin proposals are generally aligned with the standards published by the Basel Committee and IOSCO, there are some material differences that will pose challenges for market participants in any cross-border context. As derivatives businesses are conducted at a global level, substituted compliance and equivalence determinations will be key.
The margin requirements become effective on September 1, 2016 for the largest derivatives market participants. Therefore, major dealers will be the first group to test new documentation, model solutions and operational mechanics, before they apply to a substantially broader group of market participants from March 2017. Mandatory margin requirements are expected to result in higher costs and reduced liquidity for non-cleared derivatives. In the end, this may cause counterparties to relinquish the use of derivative hedges tailored to their risks and instead opt to hedge using less effective, but more standardised, cleared derivatives, or decide not to hedge their risks at all.
“Mandatory margin requirements are expected to result in higher costs and reduced liquidity for non-cleared derivatives”