OTC Reform #1

The Dodd-Frank bill that was signed into law in July 2010 includes important reforms of the OTC derivatives markets. These markets cover a large portion of the financial instruments currently used for risk management at non-financial corporations. The reforms have the potential to make these markets function more effectively, potentially lowering the costs of hedging. But, executed poorly, the reforms could also impede the functioning of the market.

As with all pieces of legislation, passing the bill is only one step in a long process of working out the full content of the reforms. One of the next steps is writing the myriad regulations that will define how the law is to be implemented in concrete detail. The bill mandated that this rulemaking process be completed within 360 days of the bill’s enactment. The CFTC and the SEC—the two agencies with primary responsibility for portions of the OTC derivatives markets—are actively engaged in this rulemaking process.

Throughout the rulemaking process there will be significant debate about how best to implement the reforms. We expect this debate to provide plenty of opportunity to explore the functioning of these markets for risk, how end-users utilize these markets, and other issues central to risk management, and we intend to focus a good portion of our posts on these issues. Consistent with the focus of this blog and our associated course, our attention will be on non-financial corporations—the so-called end-users—and how the proposed rules for the OTC derivatives markets affect the operation of these corporations. We won’t focus on the many other aspects of the rulemaking.

We start with a brief statement of the major objectives of the reforms of the OTC derivatives markets.

Regulatory authority. The Dodd-Frank bill gives regulators authority over essentially ALL trading in OTC derivatives. From the 1980s, a defining characteristic of the OTC derivatives market had been the lack of regulatory scrutiny. In some cases, the markets had evolved this way. In other cases—such as the infamous Enron loophole for energy derivatives markets—this lack of oversight was enshrined into law. The Dodd-Frank bill restored the principle that a well functioning market generally requires some sort of policing.

Transparency. To date, OTC derivatives markets have been among the most opaque of markets. Prices of transactions are generally not publicly available the way they are in so many other financial markets. Even the size of the markets is unclear. What data is made available is in a generally useless format that is incomparable to other markets serving similar ends, such as the commodity futures exchanges, which produce clear and meaningful statistics on their operations. The Dodd-Frank bill mandates “real-time public reporting” of transaction and pricing data. This is facilitated in part by the fact that all transactions must be reported to a trade repository. In addition, a large portion of trading will move onto exchanges and similar entities, where pricing is intended to be more transparent and competitive.

Clearing. A key feature of bilateral markets like the OTC derivatives market is the multiplication of credit risk. Participants often reduce exposure to a certain market risk by adding on an offsetting position. This reduces market risk, but increases total credit exposure. A key innovation of futures markets is the use of centralized clearing, which allows offsetting market exposures to cancel one another, reducing the total credit risk in the marketplace. OTC derivatives markets have generally functioned with much less clearing of offsetting transactions. The Dodd-Frank bill mandates clearing of all standardized OTC derivatives. And by establishing higher capital requirements for non-cleared transactions, it encourages the standardization of the derivatives being offered OTC. The objective is to reduce the total volume of credit risk in the system, and to reduce the systemic risk.

Will the Dodd-Frank bill accomplish these objectives? Stay tuned.

One Trackback

  1. […] lobbying work. We’ve already addressed the Brief’s main arguments in previous posts (start here or here), and won’t rehash those points again […]

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