Dodd-Frank to price buy-side out of OTC market – Celent

Buy-side firms will suffer increased collateral management and margin requirements under the US Dodd-Frank Act's OTC derivatives reforms, claims analyst firm Celent.
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Buy-side firms will suffer increased collateral management and margin requirements under the US Dodd-Frank Act's OTC derivatives reforms, claims analyst firm Celent.

Anshuman Jaswal, Celent senior analyst and author of the report, ”OTC Derivatives Clearing and the Buy Side in the US: Rough Ride Ahead', said that buy-side firms will have to dig deep to cover the costs of the new regulation – although sell-side institutions and clearing houses will also be affected.

“Investment management firms, brokers and clearing houses alike will have to share the burden of increased costs,” said Jaswal. “Some buy-side firms may reduce the number of OTC contracts they trade as they will be effectively priced out of the market.”

Dodd-Frank aims to move as large a proportion of OTC trading activity onto new, centrally cleared swap execution facilities (SEFs) as possible. It is hoped that this will reduce systemic risk in the OTC derivatives market, since in theory the clearing house takes on much of the risk that a counterparty will default, reducing the possibility that a default by a large counterparty could paralyse the market.

However, the Celent report suggests that buy-side firms will struggle to absorb the cost of establishing sufficient relationships with executing and clearing brokers, as well as connectivity to the main swap execution facilities and central counterparties (CCPs). Although portability would allow a buy-side firm to move its trades from one clearing member to another without losing any collateral, Jaswal points out that it remains unclear what costs the buy-side would have to incur to ensure that portability is available for its transactions.

Moreover, under the draft rules, clearing-eligible OTC derivatives will need to be executed at an SEF and reported to a swap data repository (SDR). Buy-side firms will also potentially require connectivity to all major CCPs, affirmation/confirmation platforms and SEFs. Since executing and clearing brokers are expected to pass along the costs of setting up systems and technology for connectivity, buy-side firms will likely have to pay part of the cost, as well as face their own direct costs for increased reporting obligations. As such, the cost of connectivity with up to 15 different brokers, SEFs and CCPs would add to the burden of collateral and reporting requirements to place strain on buy-side infrastructure.

Estimating the cost of collateral across the main CCPs at US$1 trillion or higher, Jaswal recommended the establishment of ”super-SEFs', aggregated platforms that could be accessed from a single point, as a means to reduce costs. “The financial implications for the entire industry are going to be severe,” he said. “Building connectivity to brokers, SEFs and CCPs, along with an adequate reporting system will not be cheap, so an aggregated SEF solution is definitely desirable.”

In August, financial consultancy TABB Group released a separate report that predicted OTC derivatives reform in both the US and Europe would cost market participants billions, due to surging data levels and the need to invest in clearing and back-office technology.

The Dodd-Frank Act has been delayed from its original July target date, following the announcement by Gary Gensler, chairman at US regulator the Commodity Futures Trading Commission in September that some of the key rules will not be implemented until 2012, including the final rules for SEFs. The regulation has also come under attack from Craig Donohue, head of Chicago-based derivatives exchange CME Group, on the basis that it does not take sufficient account of the costs and benefits of the proposed new rules.