• Paul Gibson and Kara McCaleb, Business Consultant at European investment bank


• 04:00 am
fragmentation , regulations , Paul Gibson is a Business Consultant based in New York specializing in capital market initiatives. He is currently working at a top European investment bank focused on the impacts of regulatory reform on execution, clearing and reporting workflows. About Kara McCaleb Kara McCaleb is a Business Consultant based out of New York with experience facilitating and planning large change management programs. Kara is currently working with an industry utility to develop its strategic products and services roadmap and supporting implementation plan.

In April, Sapient Global Markets, along with other market participants, descended on Montreal for ISDA’s 30th Annual General Meeting.  As noted in our pre-event blog, much of the conference focused on the impact of regulation, intended and unintended, and how firms are reacting to the changes. In particular, consideration was given to how markets are fragmenting, and what the industry can do to realize greater harmonization and standardization in response.

The tone was set by ISDA’s Chief Executive Scott O’Malia in his keynote address. Noting the number of new rules implemented over the past 18 months, he called for a “time out” to allow the markets enough time to assess the impact of the various rules. “Everybody’s looking at the individual rules and there’s no analysis of the cumulative effect of all of this,” he argued. International regulators echoed this sentiment, suggesting too much attention has been directed at regional implementation approaches when the international community should really be verifying that the changes to the market mitigate systemic risk as initially designed.

As it stands, the multi-layered, sometimes contradictory, nature of the current regulatory environment continues to cause concern. Participants’ unease traces back to individual rules as well as to the cumulative effect these new regimes have on the markets.

Trade reporting, for example, varies significantly by jurisdiction, which introduces contradictions that increase the operational costs to implement rules and prevent regulators from efficiently aggregating global data to assess risk. Similarly, new capital rules might make the market safer in the short term, but with the depth of liquidity resultantly diminishing in some areas, the rules when taken altogether may actually make some markets less stable. 

Viewed collectively, O’Malia openly questioned whether new capital, leverage and trading rules are limiting banks' ability to provide liquidity, and asked the industry how market structure must adapt to support.

Harmonization to counter fragmentation

Despite growing regulatory fatigue, it was highlighted that the industry has implemented just about 15% of the post 2008 crisis rules globally to date, and there are undoubtedly complexities on the horizon that will further fracture markets if not thoughtfully addressed. Yet the adverse impact of a jurisdictional implementation approach to regulating the OTC market is becoming ever more apparent. An ISDA survey, released during the AGM, revealed that 55% of respondents view the market fragmenting along geographic lines due to staggered regulatory timelines in the US and the rest of the world.

So how are firms reacting? Speaking at the event, a significant global hedge fund highlighted how regulatory changes and the associated costs have led it to re-examine its operational model. Specifically, this firm is now looking to share its swaps business with more industry players to limit costs incurred from the new margin rules and threshold limits. Concerns remain that thresholds could be applied differently on either side of the Atlantic, with Europeans facing fund-level thresholds while their US competitors are constrained by firm-level requirements.

There is also the ongoing issue surrounding twin-speed clearing mandates, particularly after the EC has called for a further delay (the third to date)  to approve the supervisory regime for foreign CCPs. A number of panel discussions during the event and our own experience with firms indicate that European firms may abandon US clearinghouses if this isn’t soon resolved.

Standardization and optimization

Despite these complexities, we had a number of interesting and positive conversations with firms about how to mitigate these challenges. Some are examining how they can take a more holistic approach to managing regulatory change, including group-wide capital management strategies, governance structure changes and comprehensive data management approaches. Firms also recognize the need to optimize new relationships to ensure they make sense from a regulatory perceptive while also delivering commercial value to the firm.

Operationally, firms have a great deal to consider. As further electronic trading rules are finalized, participants will need to review and select electronic trading platforms—a process that requires the rationalization of existing platform connections so as not to incur unnecessary costs.  Trade execution will require effective order aggregation and smart routing for best execution, while data analytics will play a role to ensure collateral efficiency, leveraging CCP margin calculations based on real-time market prices. Trade capture, confirmation and clearing processes will require system rationalization across asset classes and products, especially given OTC and ETD convergence.

Then there are the issues that stem from trade reporting. Inevitably, these discussions return to data quality and a call for global standards. With the requirements across jurisdictions so uneven, market participants are unable to report one single record to a TR to satisfy their global reporting obligations. Panelists and conference attendees agreed that global standards for trade reporting must be introduced if the industry is to improve the quality of data reported and realize the main goal of post-trade transparency regimes: reducing systemic risk. Some significant achievements at the trade repository level were highlighted throughout the week, including a push to implement new validation requirements globally. We expect to see much progress in this area over the coming 12 months, particularly given ESMA’s increased focus on validation standards. 

Conclusion

Overall, while progress has been made, conference discussions highlighted that significant market structure issues remain. Disjointed regulatory rules force banks to analyze which businesses to support and which to exit, which products to offer or trade, and how to best price their services.

The post-reform landscape has wide-ranging implications for both the sell side and the end users of derivative transactions. To fully capture the opportunities emerging with this fundamental power shift away from dealers, market participants need to evolve their strategies, reengineer their business models, delineate their differentiated capabilities and build new partnerships.

It will be interesting to see, by the time the next ISDA AGM comes around, how far the industry has come in tackling these costly concerns and whether the data quality issues that have plagued trade reporting to date have shown marked improvement.