The DoddâFrank Wall Street Reform and Consumer Protection Act intends to introduce significant changes to the US overâtheâcounter (OTC) derivatives market, with the goals of improving transparency, reducing systemic default risk and promoting greater stability. The costs and lack of clarity associated with this bold endeavour have far reaching consequences.
Counting the cost
According to The Government Accountability Office regulators will need to spend at least $1.25 billion to enforce the new laws outlined in the Dodd-Frank Bill over the next two years (1). Law makers are required to write approximately 300 rules that will touch almost everything within the financial space, including the $600 trillion derivatives market. Clearly, the challenges associated with meeting the self imposed regulatory deadlines for rule creation are at risk without this funding, and that leads to additional costs for the industry. The large amount of uncertainty pertaining to the status of Dodd-Frank prevents the market from committing a full cache of resources to complying with what many believe to be a âmoving targetâ.
The reluctance to commit capital in the face of changing regulatory requirements is understandable. For example, it is unreasonable to ask companies to invest in unknowns, like swaps reporting, without a greater understanding of the requirements associated with a compliant response. In a large number of investment houses, analysts are trying to assess the initial margin costs tied to using different central clearing counterparties, but how do we quantify the opportunity costs borne by the industry while we wait for greater clarity on so many rules? How do we value the risk of potential unintended consequences?
The fear of unintended consequences
The Dodd-Frank bill is just one piece of the global regulatory puzzle, with Europe and Asia also looking to adopt regulatory changes. Those regions are likely to use Dodd-Frank as a guide for their own derivatives regulation, in an effort to maintain some level of consistency worldwide. Clearly we run a risk if one region acts too quickly without a mindful effort of moving in harmony with the rest. Unfortunately, it is very difficult to get international regulators to synchronise their efforts at both the grand and granular levels, so this is a work in progress. Though it remains to be seen, potential regulatory arbitrage could have a significant effect on the global markets. The threat of a radical swing in market behaviour certainly creates the added element of fear for everyone involved. The likelihood of broad shifts in capital to venues with âmarket-friendlyâ practices are more likely to be addressed sooner rather than later by regulators to prevent some kind of gross regulatory arbitrage but the threat still exists.
Many question if âwe have gone too farâ by including the significantly larger rate derivatives business in the regulatory overhaul. What sacrifices will end-user firms need to make to comply with this model in the larger rate derivatives space? Will we swap perceived systemic risk on their part with a greater likelihood of more individual risk as they conform their traditional hedging activities to meet the requirements of government-imposed clearing and standardisation mandates?
This is a radical shift in market structure as we have historically known it. No one disputes that there are too many moving parts associated here to expect everything to go exactly as planned. It is going to be the responsibility of the regulators, in partnership with the market community, to carefully manage the process and keep an open mind toward revision on a forward basis to prevent an unintended outcome.
Future impact on the derivatives market
The positive longer-term effects of the Dodd-Frank bill should include a greater level of transparency, liquidity and standardisation for many products. The challenges associated with the new rules will tie up more capital and place a higher premium on collateral efficiencies to mitigate costs. New products may pop up down the road in a âSon of Frankensteinâ scenario. Ultimately, it may take longer than anticipated, but the potential for a more efficient derivatives landscape is common ground for almost everybody and that is the desired longer-term effect.
One of the beauties of our industry lies in the fluidity of change. Markets respond very quickly to events on the ground, both rumours and facts. Can regulators do the same? There could be tremendous benefits to scaling back the initial scope of Dodd-Frank and introducing a staged approach to implementation. Some of the US Commodity Futures Trading Commission (CFTC) commissioners have called for a more limited approach to regulation that carefully monitors the impact of change and many others have echoed their concern.
One way to accomplish this is may be to isolate a portion of the broad derivatives market, as opposed to taking the big bang approach to regulatory reform. For instance, there are compelling arguments for limiting the initial government effort to the credit derivatives sector. That would be a measured response to what was considered the epicentre of the financial meltdown. Regulators could address a significant amount of the systemic risk that global reform was intent on covering, while lessening the regulatory cost burden along the way. There is very little evidence that interest rate derivatives trading was responsible for the deep damage done in 2008. When you consider that interest rate derivatives cover roughly 85 per cent of all derivatives activity, the cost savings for regulators, taxpayers and business interests would provide some promising relief while we assess the results of governmental regulatory efforts on the CDS markets.
In addition, for a variety of reasons, the credit market is significantly better positioned for many of the changes mandated by Dodd Frank. The credit derivatives community adoption of the âBig Bangâ self-regulatory reform in April 2009 resulted in greater standardisation for both indices and single name CDS. The implementation of standard spreads, in conjunction with scheduled settlement dates, lent credence to the prospects of an orderly market where liquid trading, clearing and regulatory oversight could add value. Washington subsequently mandated the electronic trading, clearing and reporting of almost all derivatives activity.
Challenges lead to opportunities
It is crystal clear that things have changed and will continue to change. Once the outline is finalised and the industry has a greater sense of clarity, we are confident that the large majority of firms will be ready at the macro level. The mixture of talent and technology in our industry is too powerful to expect anything less than a general willingness and capability to comply. Naturally, there will be a certain amount of last minute scrambling to help this materialise, including resource requirements in legal, credit, risk and IT departments.
One thing is for certain - as the fog continues to lift, we stand at a critical juncture in the financial markets landscape. While we face challenges we also have opportunities. The opportunities to mitigate operational risk, benefit from transparency and enjoy greater reconciliation offer promising returns to those willing to plan for change. Hopefully, by building for the evolution of our business as opposed to a revolution, we can prepare for the contingencies of tomorrow at lower costs today.
1. A Year Later, Dodd-Frank Delays Are Piling Up NY Times article