Regulatory reform

and OTC derivatives

A look at key changes reshaping the market. And four predictions.
By Joe Anastasio and Pramod Achanta, Partners

At a glance markets. And it suggests key questions firms should

consider as they reshape their business models to
The Dodd-Frank Wall Street Reform and Consumer meet the new regulatory requirements.
Protection Act imposes substantial new regulatory
requirements on the over-the-counter (OTC)
derivative business in the United States. OTC market
participants are mandated to comply with provisions
OTC derivatives markets and Dodd-
of the act by July 12, 2011.
Frank: Key provisions
Dodd-Frank introduces new requirements to the
The legislative authors laid out an aggressive
OTC market, including mandated use of central
timetable for rulemaking to implement Dodd-Frank.
counterparties and trade repositories and more
However, the process has been slower than expected,
stringent transaction reporting deadlines.
and the bulk of the rules remain to be established.
Still, the act will unquestionably cause profound
changes on how OTC derivative markets operate. Mandatory use of central counterparties
for eligible contracts
Other regions are watching closely to see what
Historically OTC derivatives trades have been bilateral
changes unfold in the new U.S. regulatory regime.
transactions between two market participants. Only
Rulemaking for the European Market Infrastructure
those two parties knew the details of the trade, a
Legislation (EMIL) proposed by the European
lack of disclosure that contributed to the credit crisis.
Commission is to be completed by the end of 2011
Under Dodd-Frank, all OTC derivatives contracts will
for implementation a year later. Emerging markets and
be required to clear through a central counterparty
other G20 countries have different timelines and are
(CCP), also known as a derivatives clearing
early in their legislative processes.
organization (DCO), which will provide transparency
into all open transactions (see Table 1 on page 2, The
This white paper outlines key elements of the Dodd-
new nomenclature for derivatives market participants).
Frank Act affecting OTC derivatives trading, as well as
an update on the status of rulemaking. The paper also
discusses four possible effects, both intended and
unintended, that the act is likely to have on derivatives
Name Definition Representative names

Swap Execution Regulated market place for derivatives trading Bloomberg, MarketAxess
Facilities (SEF)

Derivatives Clearing An entity that registers with CFTC to act as a central CME, LCH, NYPC
Organization (CCP) counterparty in derivatives clearing and settlement
process. SIDCO ► Systematically important DCO

Swap Dealer (SD) Market maker in swaps. Notional amount of swaps JP Morgan, Citi
traded exceeds $100M over last 12 months

Major Swap Party maintaining substantial position in swaps or with Most financial institutions
Participant (MSP) outstanding swaps that create substantial counterparty trading Derivatives (incl.
risk or highly leveraged with no established capital Money Managers, Big
requirement. Substantial Position = Daily average current Hedge Funds)
uncollateralized exposure of $1B (for rates $3B)

Eligible Contract Entities can do OTC derivatives on a bilateral basis solely Corporate treasuries
Participant (ECP) for hedging purposes (e.g., P&G, Coca Cola)

Swap Data Entities that collect and maintain data and information DTCC Deriv/SERV TIW
Repositories (SDR) related to swap transactions. To be made available to
national and foreign regulators upon request

Table 1. The new nomenclature for derivatives market participants

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Regulators will be able to monitor marketwide risk
management and predict mark-to-market effects, as
well as prevent systemic risks resulting from market
player defaults.
Some market participants warn that the CCP structure
could lead to a two-level market system. The capital
costs associated with membership in a CCP are
significant. Members must post a guarantee fee
upfront, an initial margin for each trade and a variation
margin based on market fluctuation.
Not every bank or entity with derivatives in its
portfolio will be able to afford these costs and
create the required economies of scale. As a result,
there could potentially be a limited number of major
broker-dealers that are CCP members, with other
firms sending transactions through these dealers.
The concentration of risk created by this has
prompted consideration of whether CCP membership
requirements need to be relaxed to allow smaller firms
to be part of the CCP network.
In addition, because CCPs are a new concept for OTC
derivatives, the rules governing them are still being
written and remain in flux. While some assumptions
can be made from how corporate bonds, equities and
other asset classes work, derivatives behave in unique
ways. As a result, many players continue to remain on
the sidelines until the final rules are adopted.
Mandatory execution of swaps on swap
execution facilities or designated contract
markets
The Dodd-Frank Act mandates execution of
designated swaps between swap dealers and major
swap participants through swap execution facilities
(SEFs) or designated contract markets. If the swaps
are not in the designated list to be maintained by the
U.S. Commodity Futures Trading Commission (CFTC)
and/or U.S. Securities and Exchange Commission
(SEC), or if one of the participants in the trade is
an eligible contract participant (ECP), the swaps
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can continue to be traded on a bilateral basis. By
moving the majority of swap executions to electronic
platforms, regulators aim to create an efficient price
discovery mechanism to enhance liquidity.
Electronic execution platforms are not new to OTC
derivatives. They have seen limited success to date
because trades in this market are highly customized
to meet specific cash flow requirements and require
several iterations of negotiation between the two
parties. Mandatory execution of swaps on SEFs may
force the industry to simplify and standardize the
trades. At the same time, standardization of swaps may
require firms to create a portfolio of trades to achieve
desired cash flow and risk management objectives,
potentially resulting in higher transaction costs.
Mandatory use of trade repositories and
enhanced trade reporting requirements
A provision of Dodd-Frank aimed at increasing
transparency is the requirement to use trade
repositories to report transactions to regulatory
agencies in near real-time. The regulatory authorities
clearly want to avoid a repeat of the credit crisis, when
a lack of visibility and information prevented them
from assessing and understanding the risks in the
market. The intent of the new requirement is to give
regulators knowledge of factors including what the
trade is, what kind of exposure it has and whether or
not it’s being marked to market on the proper basis.
Firms must also comply with stringent requirements
for reporting cleared and bilateral OTC derivatives
trades executed on an execution facility or a regulated
exchange. Today such trades are not reported at all.
Trades done through an execution facility must
be reported in real time, while those handled on a
regulated exchange must be reported in 15 minutes.
Trades involving an eligible contract participant must
be reported within a day.
A major challenge in dealing with the array of new
reporting requirements is aggregating information from
the multiple-CCP structure. How will all trade data
be compiled in a single place? Do regulatory bodies
have jurisdiction and ability to access and process the
trade reporting data?
What’s the status of rulemaking?
The Dodd-Frank Act required the CFTC and SEC
to establish rules and definitions for the new
OTC derivatives by year-end 2010 so that market
participants could comply with the year-end 2011
deadline. The CFTC took the lead in the process,
identifying 30 rulemaking areas and initiating six
separate studies.
However, the rulemaking process is running behind
schedule. So far, the CFTC has issued more than
60 rule proposals, with only two finalized to date.
Despite skepticism from industry participants and
lawmakers, the commission is accelerating the
rulemaking process to meet the July 2011 deadline.
CFTC Chairman Gary Gensler has acknowledged the
possibility of missing the deadline for some of the
rules, blaming the delay on budgetary constraints.
Four predictions for the new era
in OTC derivatives
While much remains to be resolved through rule-
making, we believe some effects of the new OTC
regulatory environment will be:
1. Yes, there will be regulatory arbitrage.
The United States, the European Union, Japan and
other leading countries have shown commendable
coordination and resolve to address the aftermath
of the credit crisis. The leaders of the G20 formally
committed to reforming OTC derivatives markets at
the Pittsburgh summit in September 2009.
Despite these best intentions, we believe the
regulations will differ across various markets. The
United States has taken the first steps in defining rules
to be enforced in July 2011. Several exemptions are
already being proposed to keep a sizable portion of
the OTC derivatives outside the clearing purview.
The European regulation scheduled to take effect at
the end of 2012 is expected to be more restrictive
regarding product and participant exemptions.
Japanese regulations are likely to be delayed by the
earthquake and tsunami. Emerging markets are not as
severely affected by the credit crisis as the developed
nations and thus are likely to be less restrictive in their
rulemaking.
Timing and regional differences across specific rules
are likely to result in opportunities for regulatory
arbitrage. While the authorities may eventually be able
to close the gaps, smarter players will find ways to
benefit from arbitrage in the short to medium term.
Jurisdictions with more accommodative regulatory
1 frameworks may attract business and lead firms
to rethink where they locate their trading and sales
activities around OTC derivatives.
2. Derivatives will become cheaper,
eventually!
There is a growing consensus for the point of view
that the Dodd-Frank Act’s mandatory clearing
and stringent margin requirements will make OTC
derivatives trades more expensive. In the short run
that may indeed be the case, as the market digests
the new regulation and its secondary effects.
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However, in the long run we believe the new
environment will create greater transparency, tighter
pricing and more confidence among participants. The
establishment of SEFs and clearing OTC derivatives
through CCPs will facilitate efficient price discovery
and attract more players to the market. Today, large
premiums are factored into transactions to account
for counterparty as well as systemic default risks. In
a mark-to-market, transparent CCP environment, the
risk is being spread across the market, which typically
results in smaller spreads. For example, before Ginnie
Mae went into a clearing environment, trade spreads
and markups were more generous. With organized
settlement, they became more commodity-like.2,3
SEFs will also spur product creativity by
commoditizing derivatives and reducing the ticket
size, thus making them more viable for new entrants.
Enhanced liquidity and innovative margin netting and
pooling models will allow CCPs to offer competitive
clearing arrangements that will compensate for the
higher margin and collateral requirements.
3. CCPs: Too many, not all will last.
To capitalize on the central theme of OTC derivatives
reform, a number of firms, mostly exchanges, have
launched central counterparty services. At last count,
14 CCP services are in various stages of operation. In
addition, several countries are considering mandating
an in-country CCP for OTC derivatives that involve
resident legal entities.
While competition is good in most cases, several
issues arise with a multiple CCP structure:
• CCPs operate under different regulations in
different countries – The potential to offer different
levels of protection for in-country and external
clearing members could add a “CCP spread” to
the transaction cost.
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• CCPs may engage in a “race to the bottom” to gain
traction in a crowded market – There are already
visible signs of this phenomenon. Even with limited
or no expertise in OTC derivatives clearing and
valuation, various CCPs have proposed a wide
variety of margin netting and pooling models to
provide their potential clearing members with
“economies of scale.” Regulators are lending a
hand by limiting the membership fee to a maximum
of $50 million, rather than one proportional to the
size and risk profile of the clearing member.
• There is a lack of interoperability standards and
guidelines among CCPs – This will allow large
derivatives players, notably SEFs and swap
dealers, to maneuver clearing traffic to favored
CCPs, making others vulnerable to higher costs
and risks.
We expect that only a few CCPs will survive and
be viable. The remainder will either merge with a
dominant player or wind down their operations.
4. Derivatives clearing will be less about
clearing and more about adding value.
Some broker-dealers have announced plans to
provide clearing services for OTC derivatives.
Others are waiting on the sidelines to see how the
marketplace will develop. Currently derivatives
clearing services are primarily focused on providing
connectivity to various CCPs and standardizing
interfaces to access the service—in other words,
creating the technology infrastructure for CCP
connectivity.
These services are likely to meet success in the
short term as many firms will be reluctant to lock up
precious capital and resources to become a direct
clearing member. However, over time, we believe
regulators will encourage greater direct participation in
the CCP framework by lowering capital requirements.
Connectivity to CCPs will become standardized
through innovative technology product offerings.
The sustained success of a derivatives clearing
service will depend primarily on its ability to provide
value-added services, such as offering cross-product
collateral management efficiencies, enhanced client
services, regulatory reporting and funding. Firms with
a strategic vision and design for derivatives clearing
services are likely to succeed and gain market share
as the clearing model matures.
More developments on the way:
Can you stay ahead of the game?
Whatever form U.S. rules governing OTC derivatives
take, ultimately they will operate alongside guidelines
in other parts of the world. While the goal of regulatory
harmonization across major market centers is
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laudable and widely supported, there will be at least
an 18-month gap in the effective dates of U.S. and
European regulations. And it remains to be determined
whether the final rules in Europe and the United States
will be similar and, if so, in what ways.
Despite the continuing uncertainties, firms need to
prepare for the new order. Have you assessed the
impact on your organization and specific business
segments? Do you understand the timeline for rule
implementation and are you preparing for it? Do
you want to be a clearing member, or if not do you
know which one to use? Have you considered the
opportunities the new environment presents beyond
simply compliance? Exploring these questions can
help you prepare for the new derivatives world that will
certainly have a different shape from the past.
Footnotes
 udget woes may cause swap rule delays: Gensler, Reuters,
1. B
10/29/10, http://www.reuters.com/article/2010/10/30/us-
financial-regulation-gensler-idUSTRE69T00H20101030
2. M
 EMORANDUM FOR: All Participants in Ginnie Mae Programs,
U.S. Department of Housing and Urban Development, 3/15/01,
https://www.ginniemae.gov/apm/apm_pdf/01-07.pdf
 ublic Policy and Secondary Mortgage Markets, Freddie Mac,
3. P
3/2003, http://ihfp.wharton.upenn.edu/2009Readings/Van%20
Order%20-%20Public%20Policy.pdf
 Joe Anastasio is a founding
Partner at Capco and the Co-
Leader of the Capital Markets
group in North America. Joe has
over three decades of experience
in the capital markets industry
and is responsible for key client
relationships and consulting
project delivery in North America.
He specializes in Operations
Transformation, particularly its impact on profitability
and the client experience. Joe is a frequent spokesman
to financial media and has served on several industry
boards, including those of the National Securities Clearing
Corporation, Mortgage Backed Securities Clearing Corp.
and Euroclear.
joe.anastasio@capco.com

Pramod Achanta is a Partner

in the Capital Markets practice.
Pramod has over 18 years
of experience in the financial
services industry and focuses on
Capital Markets transformation
initiatives. Pramod specializes
in providing innovative solutions
to industry participants, from
strategy to execution, across
all asset classes. Pramod is well versed with trading, risk
and operations processes as well as technology solutions
supporting Capital Markets. Pramod joined Capco from
IBM where he served as an Associate Partner.
pramod.achanta@capco.com

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