OTC regulatory complexity fosters clearing insecurity

OTC Clearing: part 2

“[…] The financial crisis that began in 2007 had its origins precisely in over-complex regulation.”

These are the wise words of Niall Ferguson, Professor of History at Harvard, speaking at this year’s BBC Reith Lectures. He goes on to cite Dodd-Frank as a near-perfect example of excessive complexity in legislation.

Those of you who had the pleasure of sifting through the proposed rules, discussion papers, and guidance will agree that the inherent complexity is immense. The recent Dodd-Frank progress report by law firm Davis Polk cites that the two years since Dodd-Frank’s passage have seen 848 pages of statutory text expand to 8,843 pages of regulations.

For OTC players, trying to align current timelines in the regulatory onslaught is tricky, and continuous, given:

• Dodd-Frank: Q4 2012
• EMIR: Early 2013 (although this may be moved out by 6 months)
• Basel III: Early 2013

The counterparty-driven credit value adjustment (CVA) charge for bilateral OTC derivatives which Basel III introduces can easily triple the core capital needs of today. There is currently no CVA charge for cleared OTC derivatives, but if EMIR comes into force six months after Basel III what will financial institutions do in the meantime? From where will the necessary additional core capital be raised?

In the US, the SEC and CFTC have come up with exemptions for clearing obligations. Financial institutions with less than a $10bn balance sheet do not need to clear OTC derivatives. Some co-ops are exempt as are corporates which use derivatives to hedge commercial risk. Some of these exemptions find their correspondence in EMIR but others don’t.

As a consequence of this complexity, market participants are unsure with whom they will be able to clear OTC trades. This will also have a material impact on the pricing of products. In addition to these looming deadlines there is the overhaul of MiFID (the ‘Markets in Financial Instruments Directive’) which is also in the pipeline. Once Dodd-Frank and EMIR are actually ‘up and running’, it is likely that Dodd-Frank II and EMIR II won’t be far around the corner, not to mention Basel IV.

Look out for part 3 of this OTC clearing blog series which will cover extraterritoriality.