Expect the unexpected

Impending regulation will demand major changes to the businesses of market participants and infrastructure providers. But trying to second-guess the regulators could be a risky option.
By None

I hear and read about new regulation every day but what should I actually be preparing for?

The fact is that right now it's hard to prepare for the majority of substantial changes that the market will face in the coming months and years. Political standoffs and fierce industry lobbying have slowed the framing of major changes designed to bolster the financial industry.

Which pieces of legislation in particular have stalled?

The US's Dodd-Frank Act is the clearest example, with the latest delays announced earlier this month. Initially due for implementation on 16 July 2011, one year after the bill's enactment, parts of the legislation relating to over-the-counter (OTC) derivatives reform have been slowed, first until the end of this year and now until Q4 2012. The Volcker Rule, another section of the Dodd-Frank Act that bans proprietary trading and limits investment in private equity and hedge funds, also faces a delay, as regulators have not yet agreed on a draft proposal.

It's a similar story in Europe, with the European market infrastructure regulation (EMIR) – the EU's plan for OTC derivatives reform – and MiFID II also suffering a series of holdups.

But let's not be too harsh on regulators; trying to reform an OTC derivatives market that had over US$600 trillion – that's ten times global GDP – in notional value outstanding at the end of 2010, while trying to placate market participants that need to overhaul entire businesses is no easy feat.

But surely the regulators' direction of travel must pretty be clear by now?

That's true. You can expect OTC derivatives reform to push the most liquid and most easily standardised products to be centrally-cleared so that they can be traded on exchange-like platforms. But what is not yet known, in the US or Europe, are the specific products that will fall under the new regulation, as well as the rules that govern the venues that will offer OTC derivatives trading.

Many areas covered by MiFID II are anyone's guess. Leaked documents from the European Commission revealed plans for a new piece of regulation alongside the revised directive. The regulation, which allows no room for interpretation during national implementation, addresses issues including pre- and post-trade transparency, data reporting and some aspects of OTC derivatives reform relating to exchange and clearing house access that are also being addressed via EMIR.

MEPs such as Kay Swinburne and Markus Ferber, the latter recently appointed as rapporteur for the European Parliament as part of the MiFID review, suggest that transparency, controls on high-frequency trading and dark trading will be front of mind when the European Parliament considers MiFID II.

So how should the industry prepare for regulations that are not yet set in stone?

No doubt the buy- and sell-side are already considering the practical implications of regulatory reform on their businesses.

For example, as part of preparations for OTC derivatives reform, buy-side firms are looking at the need to implement robust collateral management procedures, to replace existing processes that were typically ad hoc and bilateral. Without optimal ways to manage collateral, the buy-side could face liquidity issues as they attempt to meet increased capital demands.

Derivative platform operators have also started to ready themselves, with Bloomberg and Tradeweb among the firms that have started to reposition their derivatives trading venues to meet the criteria for swap execution facilities laid out in Dodd-Frank. Furthermore, a working group comprising investment banks has begun an initiative to encourage the use of FIX for interest rate swap and credit default swap trading in expectation of the increased demand for electronic trading in these instruments once the new regulations are adopted.

In equities, investment banks have introduced multilateral trading facilities to complement or replace their broker crossing networks, partly in preparation for a regulatory clampdown on internal crossing as part of MiFID II.

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