Current European and US proposals on over-the-counter derivatives will fundamentally change both the operational and economic structure of the marketplace. Even though final rules are still being drafted and have been delayed, implementation timetables may start in 2012. Firms should therefore assess the strategic and operational impact of current proposals – on their pricing, product and booking strategies, data quality, capability of existing reporting and risk governance – to ensure their readiness.
For market participants, the proposed changes will drive a significant increase in the cost of derivatives as a result of increased capital, collateral and margin requirements. The operational costs of more data and reporting, changes to booking systems and enhanced risk management requirements will also raise overall costs, at the same time that more transparency is likely to put pressure on margins.
In parallel, financial institutions will be grappling with other major regulatory change initiatives which will also have an impact on the scope and capital cost of trading businesses, and increase the compliance cost and complexity across the industry. In combination, these pressures will reduce the attractiveness of derivatives trading in general and more speculative (and profitable) activities in particular, simplifying products and reducing volumes in more peripheral asset classes.
Firms must respond, and those looking to lead rather than lag in the new regulatory landscape must fundamentally review their business model, cost structures, use of capital and competitive positioning to reshape their business. The end business model for successful firms must be more cost efficient, with a clear focus on either scale flow business or as a niche risk specialist.
- Proposed rules over derivatives are game changing – the economics and infrastructure of the industry will change fundamentally with return on equity (ROEs) down as much as 7–10 percentage points for major sell side players.
- Pressure on ROEs resulting from higher capital, could reduce trade volumes up to 30 percent, with complex asset classes making up the bulk of the decline.
- Centralised market infrastructure takes a dominant role, and procedures over capital, risk management and governance must respond to new supervisory intensity.
- Pressure on operational infrastructure to meet heightened risk management and reporting requirements will drive increased automation and benefit larger players who can absorb large implementation costs.
- Buy side participants will share the burden through higher pricing for risk management and may elect to reduce activity in the market.
The likelihood of unintended consequences escalates as the ‘jigsaw’ of regulatory change comes together, but as yet there has been no clear market analysis which looks at the impacts on volumes, pricing, and other wider commercial activity that derivatives trading supports. Some of these consequences may include:
- regulatory overload – ability of regulators to draft a large number of rules and take on additional supervisory requirements
- systemic risks of CCPs – CCPs likely to be classed as systemically important
- uneven regulation – despite best intentions we may end up with a patchwork of national rules, which are broadly but not wholly consistent
- extraterritoriality and interoperability – limited or no recognition of equivalent local regulatory regimes, third country CCPs and trade repositories.
For banks there will be fundamental decisions about which lines of business you continue to engage in, how you trade, with whom, and where you book those trades.