OTC derivative costs and compliance burden rockets

By:
Duncan Kerr
Published on:

More than 200 of the world’s largest companies and financial institutions have warned that regulation impacting the multi-trillion dollar over-the-counter (OTC) derivatives market has multiplied their administrative burden and pushed hedging costs up to new highs.

In a survey conducted by the International Swaps and Derivatives Association (ISDA), an industry trade body, some 68% of 200-plus companies and financial institutions that responded said new financial regulation is increasing costs related to derivative hedging, with 81% stating that the administrative burden has increased substantially.

The results, published this week, throw into sharp relief the negative impact that regulation is partly having on the ability of companies and financial institutions to mitigate risks by using derivatives such as interest rate and credit default swaps.

Worryingly, nearly half of the respondents said they see market fragmentation occurring along geographic lines as a result of regulatory framework being put in place, with 61% of those respondents believing this is having a negative impact on their company’s ability to manage risk.

In addition, 83% of those respondents believe market fragmentation is increasing the cost of OTC derivatives, the survey stated.

“There are concerns about the costs and complexity [of the rules] and how liquidity may be harmed,” said Alan Haywood, president, downstream gas and head of commercial development at BP, who was quoted by the Wall Street Journal.

This fragmentation is most acute in the euro interest-rate swap market, according to ISDA, which said earlier this year it was undergoing a breakdown in cross-border trading relationships.

“Fragmentation is disrupting the market for euro interest-rate swaps as liquidity pools have become more exclusive amongst European dealers,” it stated.

The Dodd-Frank Act in the US and Europe’s European Market Infrastructure Regulation are the main pieces of regulation impacting the global derivatives market.

However, instead of reducing the widespread use of OTC derivatives by increasing the cost and burden of compliance, 86% of the survey respondents said they believe OTC derivatives remain fundamentally important to their risk-management strategy.

“As the OTC derivatives market continues to evolve amidst significant changes, it is clear that end-users around the world want and need the ability to use these instruments to manage the risks arising from their business and financing activities,” said Stephen O’Connor, ISDA chairman, and former Morgan Stanley banker.

On being asked to rank the importance of those factors that could enhance the safety of the financial system, 86% of respondents said tighter credit risk management, 79% said capital requirements and 76% said reduction of leverage. Central clearing mandates (32%), trade execution requirements (34%) and transaction reporting requirements (30%) were seen as less important, according to the respondents.