By: Thomas E. Holber
The Commodities Futures Trading Commission (the “CFTC”) adopted rules on March 20th designed to raise competition and mitigate risk in derivatives markets. Overall, however, the main thrust of the rules is to encourage migration of much of the derivatives market onto central clearinghouses.
Several features of the rules encourage competition. A key requirement is that a trade between two counterparties must be confirmed within minutes of its execution. Previously, confirming a trade could take hours or days. Requiring immediate clearing provides market participants confidence in the counterparty on the other side of the trade. Under an OTC (over-the-counter or non-clearinghouse) regime, market participants sought such confidence by flocking to fifteen large derivatives dealers representing almost 90% of the derivatives market. Critics of immediate clearing note that while OTC dealers set relatively high barriers to trading, dealer eligibility under the CFTC regime depends only on satisfying broad credit risk guidelines.
Other aspects of the rules are aimed at mitigating systemic risk. Executing trades on a clearinghouse encourages derivative counterparties to enter into transactions with one central clearing party, instead of depending upon the credit risk of large financial institutions that are “too big to fail.” Derivatives traders are also subject to several other credit risk requirements: dealers must “conduct ‘stress tests’ of all potentially risky customer positions, evaluate their ability to meet margin requirements every week and test all lines of credit yearly.”
Nevertheless, the financial industry has predictably criticized several features of the adopted rules. The concern with the most legitimacy is that migrating derivatives onto a clearinghouse simply makes that entity “too big to fail.” While this concern is valid and pressing, it is hard to see how centralized and fairly transparent systemic risk is not preferable to the prior regime. Banks have also commented that the clearinghouse’s relatively low credit guidelines are insufficient and will result in losses on trades with poorly capitalized dealers. The response to this argument is, perhaps, that if poorly capitalized dealers become a problem, the clearinghouse can adopt rules to mitigate it.
Moreover, there are still battles to be fought in this arena. The CFTC has not yet provided definitions associated with its rule-making. Thus, the definition of a qualifying derivative remains a matter of lobbying and debate. Likewise, the categorization of dealers and any discrepancies in their regulation is also to be determined in the future.
Ultimately, while criticism of the proposed regulatory regime is nonetheless legitimate, there is an element of dishonesty to it all. It is one thing to point out real drawbacks to the proposed regulatory regime, but even somewhat flawed rules seem preferable to continuation of the status quo ante. An anonymous comment in the Financial Times seems to articulate the bank’s real motivation: “The rules … will cut deeply into the revenues they generate from swaps trading.”