How the new OTC derivative regulations could impact the market

Scott Fung, DBA, Associate professor of finance, College of Business and Economics, California State University, East Bay

Busy executives probably haven’t read Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, so they may be surprised by the broad impact of the regulatory changes to over-the-counter (OTC) derivatives trading. In addition to fundamentally changing the way the market operates, the new laws could impact your bank’s appetite for risk, your ability to borrow funds and even your company’s hedging strategy.

OTC derivatives are traded and negotiated  without going through an exchange or other intermediaries to hedge or speculate on risk. They were largely unregulated until this act.

“Any time there’s a fundamental change in the way a market operates executives need to understand the big picture,” says Scott Fung, DBA, associate professor of finance for the College of Business and Economics at California State University, East Bay. “At a minimum, the changes require increased knowledge of the interdependent relationships between the various parties, better decision making and a review of your risk management strategies.”

Smart Business spoke with Fung about the potential impact of the new derivative regulations and how executives should prepare.

Why should executives pay attention to the new derivative regulations and their market impact?

Following the financial crisis, policymakers decided that a lack of transparency and regulations in the OTC derivative market caused system-wide instability, so they created a regulated environment and increased the oversights and reporting requirements.With any legislation, there are reverberations throughout the business community and the possibility of unintended consequences, especially when the derivatives market provides the following key economic functions:

  • Price discovery. Derivatives trading provides key information on the value of the underlying assets and serves as a predictor of future prices.
  • Operational advantages. The derivatives market offers lower transaction costs and additional market liquidity.
  • Informational and allocation efficiency. Derivatives trading enhances available market information and resource allocation.
  • Business advantages. Derivatives allow companies to engage in risk management by facilitating hedging strategies and by reconfiguring risk and return trade-offs. The market allows unwilling risk holders to transfer risks for a fixed price, which frees up cash for other investments and business expansion.

What are the legislation’s key provisions and who will be impacted?

The new legislation establishes the regulatory framework for the governance of the OTC derivatives markets and vests oversight authority in the Commodity Futures Trading Commission and the Securities and Exchange Commission. The intent is to provide greater oversight and transparency for derivative transactions such as credit default swaps, commodities and equity swaps. Although the regulations primarily apply to swap dealers and major swap participants, they also impact commercial end-users, financial institutions and corporations. Key provisions include:

  • Changes in execution processes and price discovery of OTC derivatives.
  • Changes in central counterparty clearing and clearing requirements, trading activities, capital requirements and margining of OTC derivatives.
  • Changes in the reporting of transactions and record-keeping requirements.

How are these provisions likely to fundamentally alter the OTC derivatives market?

The structural changes are supposed to improve the efficiency, stability, innovation and sustainability of derivatives markets by reducing the possibility of default, system-wide risk and financial crisis. In turn, this will improve the stability and functionality of the markets and financial institutions, ultimately impacting U.S. and global businesses. But it is unclear how these regulations will impact transaction costs, margin and collateral requirements. It’s also unknown whether they will actually curtail risk or tighten the credit market by limiting financial institutions’ hedging options along with their ability to customize derivative contracts. It will be interesting to see if the regulations produce changed trading activities and characteristics, so stay tuned.

How will the regulations impact U.S. businesses?

Any regulation that impacts the market or financial institutions impacts businesses because there’s an interdependent relationship between the various parties. Ultimately, the performance of financial markets and financial institutions affect corporate decision-making, financing opportunities, risk management and so forth. Possible benefits include enhanced functionality and stability of financial institutions, better performance of derivatives contracts, and the opportunity for end-users and institutions to better manage risk. Plus, the increased transparency and availability of information along with additional oversight could increase market participation, thereby boosting market liquidity. Possible downsides of the legislation include cost increases resulting from system complexities including transaction costs, collateral and margin requirements, and diminished customization capabilities.

How should executives prepare for the new regulations and the subsequent market changes?

Executives need to understand the interdependent relationship between financial markets, financial institutions, their suppliers and clients to see how their capital supply and financial resources could be affected. They should consider how they’re managing risk, as they may benefit from the enhanced usefulness and performance of derivative contracts. They also should look out for emerging opportunities and new financing products that may spring up. Executives need to understand the regulations’s intricacies to uncover new opportunities for risk management, financial innovation and ultimately value creation.

Scott Fung, DBA, is an associate professor of finance for the Department of Accounting and Finance, which is part of the College of Business and Economics at California State University, East Bay. Reach him at (510) 885-4863 or [email protected]

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