Consequences of the new regulatory landscape on OTC derivatives trading

Derivatives are a vital mechanism of risk-transfer, and are an essential tool for banks in providing financing and risk-management solutions to clients. They are used by every type of company in every type of industry in every part of the world. During the financial crisis, derivatives were perceived to have had a negative influence and consequently policymakers and others moved to strengthen the market and build a more robust financial system. Four years later, we need to ask: are we on the right track and headed in the right direction? To answer these questions, we need to first understand the real lessons of the financial crisis. It is increasingly clear that over-the-counter (OTC) derivatives performed their risk-transfer function effectively during this period. Key regulatory initiatives, including clearing and transparency, are making the system safer. But the impacts of further initiatives are unclear and may well lead to undesirable outcomes such as: • significantly increasing costs to derivatives users and particularly end-users; • leading to more cross-border fragmentation of markets; • increasing regulatory risk as implementing measures with broad structural impact are drafted under stressed conditions (particularly acute in European Union where there is no possible relief via US-style non-action letters); • curtailing innovation as tailor-made solutions fall victim to the pressure for standardisation (including margin requirements). All of this has the potential to make the cost of transferring non-standard risk prohibitive, potentially increasing risk in the system. As banks move forward out of the crisis, seeking to provide the best solutions to their customers’ needs and to finance the growth of the economy and industry, they must continue to engage constructively with regulators on financial reform. The task collectively facing regulators and industry is complex but essential.