By Aline van Duyn
The starting gun has been fired in one of the key races in the newly regulated derivatives markets.
US regulators on Thursday put out the first version of controversial rules which will determine how derivatives will be traded in the future. The thrust of the rules is that trading in derivatives from swaps used to hedge interest rate moves or credit derivatives used to protect against debt defaults will need to be done in a more public way.
The rules are being written by US regulators after financial reform legislation passed in the Dodd-Frank Act required an overhaul of the nearly $600,000bn private, or over-the-counter (OTC), derivatives markets. There are dozens of new rules for derivatives, covering the clearing houses which will backstop many derivatives trades, the reporting of data and definitions of which derivatives users will be subject to more stringent capital requirements.
Most have not been finalised, and banks, dealers, investors and companies are trying to assess their impact, and make any concerns and objections known to regulators before the final rules are passed next year. But the new rules around trading have the potential to shake up the derivatives market more than most others.
The reason is that trading in OTC derivatives is done privately, with the large Wall Street banks making markets. Under new regulations, derivatives that are cleared will also have to be traded in a certain way on newly created entities called "swap execution facilities", or SEFs.
The extent to which these SEFs allow the status quo to continue, or require an overhaul of derivatives trading which reduces the role of the large Wall Street banks, is a key issue.
"What's at stake are profits that the dealer community generates from market making of OTC derivatives," says Alexander Yavorsky, analyst at Moody's Investors Service. "In terms of impacting the structure of the derivatives markets and the revenues the economics of derivatives these trading rules are very important."
The proposals from the Commodity Futures Trading Commission, the regulator whose remit has been vastly expanded beyond exchange-traded futures to include vast swathes of the privately-traded swaps markets, appear to shake up the status quo considerably.
"It is nothing short of revolutionary for this market," says James Cawley, chief executive of Javelin, a trading platform that hopes to scoop up new business.
In a big change, trading in the most actively used swaps such as interest rate swaps or credit default swaps would have to be done via electronic trading systems similar to the ones used on exchanges.
There would be an alternative, with trading venues qualifying as SEFs also being allowed to use the current "request for quote" system, as long as the request for a quote to buy or sell a swap was sent to at least five participants in the trading system.
At the moment, much of the "request for quote" trading is done on a one-on-one basis. Unlike exchange-traded derivatives, the amount of trading in OTC derivatives tends to be much lower. An analysis by Tabb Group estimates that average turnover frequency for OTC derivatives is 2.7 times against 25 times for exchange-traded derivatives.
The SEF rules the full version of which have not yet been published are likely to be subject to a barrage of comments. There is already dissent on the issue among CFTC commissioners, with one of them Jill Sommers voting on Thursday against the proposal.
Although unanimous support from commissioners is not required to pass the rules, this early dissent is concerning some. The Securities and Exchange Commission, which will regulate part of the OTC markets alongside the CFTC, is expected to put forward proposals too. What ends up being the rules is, therefore, far from clear.
Indeed, despite hundreds of pages of proposed rules already published in 2010, the continued uncertainties about the details of the derivatives markets means that it remains hard for banks, investors and companies to pinpoint the cost of using derivatives in the future.
Companies including Caterpiller, Volkswagen and Ford have been meeting with regulators to express their concerns about whether they will have to cough up billions of dollars in cash to post as collateral against derivatives trades.
Even though companies also dubbed "end users" may be exempt from rules set by the CFTC and the SEC which make it mandatory to clear certain derivatives, they are still worried that other regulators such as the Federal Reserve may push banks to seek margin, or collateral. Currently, in deals struck directly between banks and companies, many companies do not have to put up cash against trades.
"If end-users are subject to margin requirements, they face the unwelcome decision of whether to tie up cash in a margin account and mitigate risk, or to not mitigate risk and have the liquidity available," says Luke Zubrod, of Chatham Financial, which is working with companies. He says companies believe the costs of putting up margin against derivatives positions would be in the "hundreds of billions of dollars".