Borrowers step up their fight against OTC derivatives regulation

Tougher regulation is coming to the derivatives market — that is inevitable after the credit crisis wreaked its havoc ­— but a growing number of MTN issuers and intermediaries are becoming increasingly vocal in rejecting moves to impose blanket standardisation across the market. Brendan Daly reports.

  • 16 Oct 2009
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Regulators on both sides of the Atlantic have been calling for tougher regulation on financial markets since the crisis struck, including the idea that all derivatives should be standardised and traded on exchanges.

Opposing this are increasing numbers of market participants and commentators who fear the threat such moves could pose.

The Association of Corporate Treasurers has been outspoken on its position on standardisation proposals. It sent a letter last Friday to Baroness Ashton, European trade commissioner, expressing its concerns about a commission staff consultation on over the counter (OTC) derivatives issued in July that is expected to be brought forward to the commission later this month.

John Grout, policy and technical director at the ACT, explains how regulation could harm companies.

"There are regulations that might increase the cost for corporations dealing in derivatives and also regulations that might induce cashflow volatility into corporations dealing in derivatives," he said. "Increasing costs are never welcome for any company and while it’s very easy for regulators to say ‘oh well it’s only a small increase in costs,’ it can add up. But issue that I think is more serious is the one that generates cashflow volatility. If a company needs to use a lot of derivatives, if margin is required, variation margin paid or received can be very large."

Market participants accept that there are advantages in some standardisation, as well as the use of trade repositories and exchanges.

"In the capital markets there is an evolution that we think is good and is already taking place in derivatives markets, which is a streamlining of processes and the implementation of useful platforms," said Ivan Zelenko, head of derivatives and structured finance at the World Bank. "This saves netting and counterparty risks for products and the market is making it happen spontaneously, so it would be good to anchor and push such evolutions to cover a broader range of products."

But blanket standardisation is seen as a cause for concern.

"What we see as a potential danger is the idea that there should be a very strict and extreme standardisation of derivatives products, meaning that those products which are not standardised will be penalised in many ways," says Zelenko. "We see that as a danger for the market and for end users, because in reality innovation and customisation are good things for the market, and if it’s penalised I think we are all going to lose."



Experimental phase

Any such blanket regulation is likely to stymie the creation of new structures in the MTN market.

"Customisation is the essence of the MTN market," said Zelenko. "If you want to create a new structure that is going to become the callable bond of tomorrow, a structure that will be used by investors and issuers, you must let people experiment. So there is a sterilising effect of standardising everything."

Grout agreed market solutions are often best, and that the products that should be standardised either have been or will be.

"There are some commodities which you deal on exchanges because that’s the only place you can deal them, and there are some things you only do with banks because there are no exchanges," he says. "In most things, the market decides for itself whether to use exchanges or OTC and, for OTC, whether to post variation margin mutually between the bank and the client. Mostly they don’t require margin."

One way to avoid adverse consequences from planned regulation may be to specifically target the financial sector and exempt non-bank issuers from standardisation.

"I think authorities quite rightly see an objective of trying to limit systemic risk in the financial sector," said Grout. "They should widely define the financial services sector, because the wider the definition the less regulatory arbitrage becomes possible. But I think they can exclude non-financial companies. Some have asked what would happen if an oil company bought a dealer broker, as has just happened with Occidental and Phibro. If you’ve defined the financial sector as offering a service to the public, the fact that Occidental owns Phibro shouldn’t change regulation for its own activities, so that’s not an issue. Non-financial issuers are a small part of the market and they are not building up large speculative positions. They are hedging underlying business."



A new hope for non-financials

A draft bill in the US two weeks ago offers hope that such an exemption is likely. The bill, introduced by Barney Frank, chairman of the Financial Services Committee, would be less stringent on non-financial end-users than the Treasury Bill proposed by the Obama administration in August.

The new bill suggests that corporate end-users of derivatives be allowed to continue trading OTC derivatives for hedging.

"It’s positive that they’re nodding in that direction, though the lawmaking process in the United States is complex," says Grout. "The fact that people are beginning to include it in drafts is encouraging. It is likely to be refined and changed, but the fact they are trying is good. I hope the commission in Europe will be able to come forward with proposals that equally try to achieve the results."

But the draft bill has far from quashed all concerns, as a statement from swap dealer Reval on Thursday indicated.

According to Jiro Okochi, CEO and co-founder of Reval, unless swap dealers have the same margin and capital posting exemption for hedges sold to corporate end-users, they will either increase prices to make it worthwhile to enter into customised swaps with corporations or may simply refrain from dealing with the hassle and costs of supporting the market.

"Some regulators have indicated that they believe all OTC derivatives should be cleared or be on an exchange, so not specifically exempting corporate end-users in the legislation is risky," Okochi said."Even if the current commissions would give corporate end-users a pass today, what happens when a new commissioner with a different view is named?"



Not all speculation

Regulation of derivatives may also inhibit the ability of some bodies to meet their mandates.

The World Bank uses derivatives to help countries achieve aims such as managing risks and meeting environmental targets.

"For the World Bank financial innovation is a way to manage risk for countries," said Zelenko. "the kind of derivatives and markets that are not the core of the MTN market, but that are very important for our member countries, things like Cat bonds or carbon finance. These are not standardised products, but they have a lot of value in terms of development and public finances for developing countries."

The EIB may also be inhibited from assisting the development of domestic markets in its member countries.

Isabelle Laurent, head of funding at the European Bank for Reconstruction and Development, said excess capital requirements on non-standardised derivatives could make it difficult for the EBRD to develop domestic capital markets in its member countries.

Many believe that there is a misconception of the threats posed by OTC transactions.

"The OTC model works very well," says Richard Metcalfe global head of public policy at the International Swaps and Derivatives Association. "It delivers, which is why it has grown to such a size. It does not make sense to say that it’s all speculative. By definition each derivative contract allows two parties to express equal and opposite views, so they can’t speculate in the same direction. It’s perfectly obvious that a very large chunk of net risk transfer through derivatives is driven by hedging."

There seems to be widespread agreement among issuers on the potential risk of overregulation and excessive standardisation.

"All issuers I know that are active in the MTN market are really on the same page when it comes to the dangers of standardisation and penalising innovation in structures and derivatives," said Zelenko. "And then there is the whole spectrum of positions regarding how to encourage streamlining and how far we should go."

Despite the calls for reason and an avoidance of blanket standardisation, many expect drives for improvements in procedures.

"While all this is happening, quietly in the background we continue to work hard on broadening the scope of central clearing, improving back office operations more generally, and tightening up procedures around the use of collateral," says Metcalfe. "There’s a lot going on behind the scenes, which we hope and believe will ultimately get factored into the regulatory approach."
  • 16 Oct 2009

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
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1 Citi 397,874.23 1502 9.03%
2 JPMorgan 363,481.85 1652 8.25%
3 Bank of America Merrill Lynch 348,228.35 1238 7.90%
4 Goldman Sachs 258,323.50 873 5.86%
5 Barclays 255,555.03 1005 5.80%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
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1 HSBC 41,871.90 183 6.88%
2 Deutsche Bank 36,549.85 129 6.00%
3 BNP Paribas 30,861.76 187 5.07%
4 Bank of America Merrill Lynch 30,788.61 98 5.06%
5 Barclays 30,558.69 87 5.02%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
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1 JPMorgan 21,646.51 97 8.83%
2 Morgan Stanley 17,632.84 92 7.19%
3 Citi 16,974.50 104 6.93%
4 UBS 16,761.62 67 6.84%
5 Goldman Sachs 16,323.87 89 6.66%