Need for a balanced and practical approach - Regulating the OTC Derivatives market

As legislators prepare to move ahead in debating the recently introduced draft bill on regulating OTC derivatives, several observers have questioned the need for the bill to be diluted, both in terms of coverage and in terms of regulatory oversight mandated. With over USD 600 trillion in notional amount & the stigma attached to CDS instruments (thanks to AIG) due to the current financial crisis, it is easy for one to be led astray and push for a total clamp-down on the market. However, we need to ensure this is looked at from the right perspective.

Regulation is very much needed and so is enhanced reporting and disclosure - without going in to an argument on Value at Risk Vs notional amounts, the very fact that US financial firms make over USD 30-40 billion+ in annual profits from such instruments gives an idea of the level of implied risk in this segment of the financial market. However, it is to be noted that not all of the volume is driven by speculative positions. To put this in perspective, a majority (65%+) of the USD 600 trillion notional pertains to Interest Rate Swaps (IRS) and close to 10% pertains to Currency swaps; and only about USD 60 trillion pertains to the much-vilified CDS bucket. And this is not to say that CDS as an instrument has any inherent flaws - it is as much necessary to create a vibrant credit market as is oil futures and options for a vibrant crude oil market.

More over, close to USD 60 trillion of the USD 600 trillion notional pertains to positions by non-financial firms, where they are hedging real risk associated with variables like interest rates, foreign exchange rates and commodity prices to reduce profit volatility related to factors not linked to their core business. Also, a significant portion of the IRS market would be covered swaps with hedged counter-positions on the books of financial services firms (banks using a pay floating-receive fixed swap to hedge interest rate risk on their floating rate loan pools for example).

To put it in a nut shell, the OTC derivatives market plays a significant role in maintaining a well-oiled financial services world. Over-regulation without understanding the true nature of the market kills the industry and reduces liquidity from the financial services market as a whole. The very nature of customization associated with loan tenures, currency positions etc is what makes the market so difficult to be managed through a pure exchange-driven mechanism. This is the very reason for large delays between trade execution and settlement, and hence accumulation of settlement risk. A regulatory push towards enhanced disclosure and reporting, and hence supervisory review of systemic risk, is a good idea - but draconian rules related to reporting or margining will add disproportionate costs and hence eventually strangles the industry.

Having said this, the directive towards moving a larger portion of the OTC Derivatives volume to central clearing houses is laudable. This is as much a solution to industry woes as for regulators' woes - the positive industry response to DTCC's Trade Information Warehouse a few years back & success of other service providers like Markit and TriOptima clearly shows that there is proven business value attached to central parties which can facilitate information exchange and drive information accuracy. However, a few points need to be noted:

• Centralized clearing houses do create systematic risk due to aggregation of risk to a single counterparty. So, unless strict norms around capitalization of these clearing houses is part of the mandate, the move could be counter-productive in the longer term.
• What is more important than centralized information is how regulators and industry uses this information. Unless there is a good mechanism to roll up exposures across related parties and highlight areas of risk concentration, along with a clear mechanism of regualting the same by supervisory oversight, the central clearing house solution doesn't provide any real relief. For example, several large US firms had exposures to multiple Lehman entities (collateral pledged with Lehman US and Lehman UK separately for example) and since analysis of rolled-up exposures to Lehman group as a whole was not done or acted upon, realization of the overall exposure happenned only post-event.
• Margining requirements have to be as tight on non-financial firms as on financial services firms. I do not personally agree with the opinion that stricter margining requirements dilutes business value for firms using it as a true hedge. I agree that it does entail added costs to doing business, but if the regulation is lax towards non-financial firms in this area, it leaves a big loop hole. Nothing stops rogue financial arms of oil companies or any others from creating Enron-like situations due to unregulated open exposures in derivative positions.

To summarize, we do need fresh regulations on facilitating centralized counterparty driven clearing, enhanced reporting and stricter margin requirements; however, regulators need to work closely with industry leaders and industry SROs to ensure that we create an environment for controlled growth and not lead to total market constriction. On the same note, we have to be careful on diluting rules for select areas of the market - since loop holes almost always are exploited by smart players in the market!