Post-Lehman: are derivatives still a risky business?

A number of regulatory frameworks have been put in place to curb banker trading and bring a new level of transparency to the industry. Martin Morris analyses the most significant changes

US President Barack Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in 2010 - the derivatives industry has seen major changes to its legislation post-Lehman Brothers
US President Barack Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in 2010 - the derivatives industry has seen major changes to its legislation post-Lehman Brothers 

For every action there is a corresponding reaction and if the world’s major banks – collectively in the dock for having blown up the global economy in the late noughties – could be sure of one thing, post-Lehman Brothers, it was that the ‘business as usual’ approach, in terms of how they conduct their OTC (over-the-counter) derivatives operations, was never going to be a serious runner – legislators and regulators on both sides of the Atlantic are seeing to that.

Politicians haven’t taken their eyes off the ball entirely, however, and some of the measures now being put in place build on pre-Lehman legislation. Yet in their quest to accelerate what amounts to a significant clampdown on the derivatives industry, the net has not only been cast wide, as legislators attempt to snare the major banking fish, it is also potentially scooping up lesser players along the way, such as industrial and trading companies. Even if the latter can subsequently gain exemptions from the various emerging regulatory frameworks, they are still going to incur additional costs for their troubles.

Core to the new post-Lehman approach has been implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) in the US, along with the EMIR (European Market Infrastructure Regulation) and MiFID II (Markets in Financial Instruments Directive) initiatives being rolled out across Europe.

MiFID II, which is likely to come into full effect in 2016, is designed, from a trading standpoint, to ensure specified OTC derivatives contracts are migrated onto recognised exchanges.

[The DFA] was seen by many outside the financial industry as a necessary evil that would not only improve the
monitoring of risk

EMIR, meanwhile, is focusing on the clearing and reporting aspects of trading, while in the US, exchange trading, clearing and reporting are contained within Title VII of the DFA.

Risk monitoring
When the DFA was signed into law in July 2010, it was seen by many outside the financial industry as a necessary evil that would not only improve the monitoring of risk within the financial system, as well as the transparency of OTC products, but also provide greater consumer protection more generally. The requirements for central clearing, an increase in capital adequacy requirements and greater regulation of the major banks, were also seen as positive developments for an industry long viewed as being out of control.

Historically, derivatives have allowed users to protect themselves against everything from moves in interest rates to the cost of raw materials. However, more complex derivative products such as swaps have generally been traded away from exchanges. Under the new regime, derivatives must be traded either on open, regulated exchanges, or via similar systems known as swap execution facilities.

Trades, in what amounts to a $600trn market, will be publicly recorded and backed (in most cases) by clearing houses who will ensure traders post money as a cushion against losses – and take fees in the process to ensure trades go ahead. Clearinghouse members will similarly be required to set aside sufficient capital to share the risk.

In part a response to claims that the clearinghouses themselves could end up becoming the next set of ‘too big to fail’ institutions, the US government has provided clearinghouses the guarantee of emergency access to Federal Reserve borrowing if required.

Trades not going through this system will be those by (non-financial) companies that have earned exemptions having proved they’re only involved in hedging risk related to their main business activity. The issue is still shrouded in uncertainty, though – for example, it is still not entirely clear whether companies running commercial leasing operations will be exempt. Of far greater certainty, however, is the likelihood of major institutions passing the increased costs involved down the food chain to customers. Institutions will not only need to spend money to determine how and if they’ll be impacted by the new legislation, they could also incur higher costs in their everyday trading activities, whether they’ve been granted exemptions or not. In addition, if the credit rating agencies opt to re-rate companies due to changed circumstances, any downgrade (if given) will likely impact in the form of higher borrowing costs (to those companies) in the wholesale markets.

In its note Dodd-Frank’s Title VII – OTC derivatives reform – Important answers for board members as companies begin the road to reform, EY argues that the new regulatory requirements will have a substantial impact on the front-to-back transaction work flow for many market participants. Tellingly, the exceptions that may apply to non-financial companies aren’t free passes either, because it will still cost money to determine whether the said exemptions do actually apply or not.

Under the new regime, derivatives must be traded either on open, regulated exchanges, or via similar systems known as swap execution facilities

It adds that while end users may be exempted from clearing and trading requirements for certain transactions, Title VII’s provisions will require modifications to their derivative-related policies and procedures and may have an impact on their working capital and liquidity. For example, the posting, by end users, of collateral under a ‘credit support arrangement’ for their uncleared trades, would require both new documentation and new operational procedures for many. ‘New record-keeping requirements still apply and some end users may need to report the terms of certain trades to ‘swap data repositories’ on a trade-by-trade basis,’ it adds.

EY further notes that while companies must meet certain criteria in order to qualify for available exemptions, they will also need to be aware of any activities that could preclude them from qualifying for these exemptions in the future.

In short, policies and procedures will need to be updated to reflect compliance with the new regulatory requirements, while new tasks will need to be completed on an ongoing, periodic basis that will incur additional costs.

The derivative landscape
At the coalface itself, latest (Q3 2013) available data in the US from the Office of the Comptroller of the Currency showed a total of 1,417 insured US commercial banks and savings associations reporting derivatives activities during the period, an increase of 17 from the previous quarter.

Derivatives activity in the US financial system continues to be dominated by a small group of major institutions – the four large commercial banks (JP Morgan, Citibank, Bank of America and Goldman Sachs) representing 93 percent of the total banking industry notional amounts and 81 percent of industry net current credit exposure.

Meanwhile, notional derivatives increased $6.2trn, or three percent, to $240trn during the period and have now increased for three consecutive quarters (see Fig. 1), after a decline in five of the previous six quarters.

Derivative contracts remain concentrated in interest rate products, which comprise 81 percent of total derivative notional amounts. Credit derivatives, meanwhile, which represent five percent of total derivatives notionals, decreased four percent from the second quarter to $12.8trn.


If the banking industry looms large in the US, its importance was underscored in October when it won a temporary political victory of sorts after the House of Representatives approved a bill allowing banks to trade certain derivatives.

Critics quickly charged that it represented a rollback of the Dodd-Frank legislation because it undermined the so-called swaps push-out rule that had required banks with access to deposit insurance or the Fed’s discount window to move their derivatives operations to separately capitalised businesses. The rollback would impact equity, some commodity and non-cleared credit derivatives. However, asset-based derivatives – chiefly to blame for the banking system implosion in 2008 – would still be banned.

Indeed, far from reducing risk it would theoretically increase it, given banks would be able to move their derivatives operations to units less subject to regulation, which in turn would impact customers further down the chain, such as farmers. Subsequently, a senate version of the House Bill has failed to advance (though may yet be revisited) and the Federal Reserve has pressed on by completing a rule giving foreign banks the chance to delay having to erect barriers between derivatives trades and their US branches.

The rule, effective January 31, treats uninsured US branches of foreign banks in the same manner as branches that have government backing, including deposit insurance.

In 2013, foreign banks, such as Standard Chartered and Société Générale, had been granted a two-year delay (until July 2015) to implement the rule. US banks, meanwhile, were given a two-year transition period to move their derivatives trading operations out of deposit-taking units.

Like Dodd-Frank, EMIR (European Market Infrastructure Regulation) brings in new requirements aimed at improving transparency and reducing the risks associated with the derivatives markets. It also imposes requirements on all types and sizes of entities that enter into any form of derivative contract, including those not involved in financial services, as well as applying indirectly to non-EU firms trading with EU firms.

EMIR brings in new requirements aimed at improving transparency and reducing the risks associated with the derivatives markets

While EMIR entered into force in August 2012, most of its provisions will only apply once technical standards go live. The new regulation requires entities entering into any form of derivative contract – including interest rate, foreign exchange, equity, credit and commodity derivatives – to report each contract to a trade repository. It also calls for new risk management standards, including operational processes and margining.

All standardised OTC derivatives contracts must be cleared through central counterparties (CCP). However, it is up to ESMA (the European Securities and Markets Authority) – with input from national regulators – to determine which contracts should be defined as ‘standardised’ and therefore subject to the clearing obligation. Meanwhile, non-standardised contracts, i.e. contracts that are not cleared centrally, will be subject to higher capital requirements in order to reduce risk. While much of EMIR’s timetable will be complete by December 1 2015, it does stretch out until December 2019 in the case of margining requirements, for example.

Investor protection
The other major piece of the EU’s regulatory jigsaw, MiFID II (Markets in Financial Instruments Directive), builds on the original MiFID, which came into effect in November 2007, and which had the primary objectives of increasing competition, improving investor protection and allowing for the EU passporting of financial products. Although it pre-dates the Lehman Brothers meltdown, like the FDA and EMIR, the updated MiFID takes account of the post-Lehman landscape by introducing a range of measures, such as improving investor protection.

It also takes account of commitments made by the G20 to improve the transparency and regulation of more opaque markets, such as derivatives. For example, MiFID II grants the authorities the right to demand information from any person regarding positions held in derivative instruments; intervene at any stage during the life of a derivative contract; take action that a position be reduced; and limit the ability of any person or class of persons from entering into a derivative contract in relation to a commodity.

In a further boost to transparency, EU member states will be required to make public a weekly report detailing the aggregate positions held by the different categories of traders for the different financial instruments traded on their platforms.

These transparency requirements will be calibrated for various types of instruments, notably equity, bonds, and derivatives and apply above specific thresholds.

While these limits and restrictions, aimed at targeting excess speculation, will be determined by ESMA and applied on a net position basis, they won’t be imposed on those positions built for hedging purposes by non-financial services firms. However, these exempted firms could still be significantly impacted due to an overall decrease in demand and supply for commodity derivatives as a result of the position limits.

EU member states will be required to make public a weekly report detailing the aggregate positions held by the different categories
of traders

If implementation of MiFID II is on a slower trajectory than EMIR, for example, it will eventually serve as a significant buttress for it.

Business as usual?
The larger question, though, is the degree to which banks on both sides of the Atlantic will be thwarted in their attempts to carry on ‘business as usual’ when it comes to derivatives trading. Given the banks’ propensity for financial innovation, the jury is still out on this, despite the attempted clampdown by regulators.

In theory, the migration of trading to regulated markets, along with increased transparency requirements, should boost competition, cut spreads and foster a higher volume, lower margin, more commoditised market. In the meantime, institutions will continue to absorb additional (and ongoing) compliance costs. It remains to be seen whether these costs will be shunted down the food chain.

However, as EY points out, greater transparency could lead to some investment banks not even bothering to make quotes, thereby driving liquidity away from the market and concentrating the business on a smaller number of pricemakers, which in turn would be less beneficial for buy-side customers. Only time will tell.