In the wake of the dramatic decline in derivatives trading volume that followed new US legislation last December, many in Europe seem reluctant to follow through on proposed changes
Lobbying by European traders and fund managers may have stalled the EU’s derivatives legislation. Some feel the delay will not dramatically affect European banks’ compliance requirements, because the majority of derivatives contracts are traded by US banks.
American institutions must comply with the Dodd-Frank Act, which applies to American banks based anywhere in the world.
The EC announced on July 31, 2012, that it had approved the European Supervisory Authorities’ (ESAs) request to postpone the deadline for setting technical guidelines on derivatives trading. It blamed the necessity of cooperating with worldwide guidelines; those recommended by the Working Group on Margining Requirements of the Basel Committee on Banking Supervision (BCBS), and the International Organisation of Securities Commissions (IOSCO).
Yet it seems the key reports by these groups have already been published. On June 6, the IOSCO published its ‘Submission of the joint draft regulatory technical standards (RTS) on risk mitigation techniques for OTC derivatives contracts not cleared by a [central counterparty]’, stipulating capital requirements for both parties.
July 25, 2012, the Basel Committee enacted two measures: firstly, a financial incentive to trade through CCPs. Trade exposures will now receive a nominal risk-weight of two percent. Second, it issued its final rule on the ‘Regulatory treatment of valuation adjustments to derivative liabilities.’ Previously, there was no specific rule adhering to derivatives which were treated like equities. After purchase, no adjustments in value could be made from in the banks’ credit risk.
Most derivative contracts, though, are used to hedge against changes in value of assets and liabilities. OTC derivative contracts are negotiated in relation to the two counterparties’ credit rating, and risk of default. The rule was clarified to state, “The offsetting between valuation adjustments arising from the bank’s own credit risk and those arising from its counterparties’ credit risk is not allowed,” when calculating equity value after the deal has been finalised.
Neil Campbell, Head of Alternative Investments at Tullet Prebon, said of the EC’s delay, “It’s slightly irrelevant because Dodd-Frank is still going ahead… Banks have made provisions for Dodd-Frank and so have brokers.” He asserted, “Derivatives houses that trade in most volume are based in America.”
The Dodd-Frank Act requires reports and due diligence be done on asset-backed securities, and be submitted to a trade depository or appropriate regulator (SEC) but there is no requirement for mandatory clearing unless “the applicable regulator determines that it is required to be cleared and a clearing organisation accepts the swap for clearing.” This mandatory clearing requirement will not apply to existing swaps if they are “reported to the applicable regulator in a timely manner,” stated a report by Morrison & Foerster.
Evidently the increased administration and transaction costs of clearing currency and commodity swaps is having an effect on demand. The Office of the Comptroller of the Currency reported US third quarter trading revenue was $13.1bn in 2011. After Dodd-Frank, it fell in Q1 2012 to $2.5bn. This pattern has been reflected in the decline in world trades, according to a recent report by the BIS.
NYSE Euronext’s July trades were down year-on-year and month-on-month across all primary trading venues. Of 7.0m global derivatives contracts, there was a 12 percent decrease compared to July 2011, and a 15.8 percent fall from June 2012. Perhaps uncertainty about pending European legislation in September is having a mixed effect on volume of European derivatives products traded: of 3.5 million contracts, there was a decrease of just 6.8 percent compared to July 2011, but a fall of 24.7 percent from June 2012.
ESMA’s private consultation, which ended 5 August, heard concerns from lobbyists including: the British Bankers Association, the Association for Financial Markets in Europe, the International Swaps and Derivatives Association and Italian banking trade body Assosim that. They protested that, by restricting the bodies allowed to trade certain derivatives contracts, the legislation would create monopolies and prevent free trading. Considering the impact the less restrictive Dodd-Frank Act has had, the EC seems unwilling to out-legislate the US.