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Hopes for reduction in liquidity risk might be flawed

Market participants are expecting a drop in liquidity risk due to upcoming derivatives regulations, but their hopes seem to be based on a misunderstanding

The overwhelming optimism towards the notion that over-the-counter derivatives regulation will reduce liquidity risk– as detailed in a new market report – is misplaced, due to a general misunderstanding of how regulations are going to impact on the industry, say capital markets consultancy GreySpark Partners.

“It seems to me [market participants] haven’t realised that the quality of collateral postedis going to need to be better under the new regulations," said Jamie Lake, managing consultant at GreySpark Partners at a press briefing on Tuesday. "There’s going to be a higher demand for high-quality collateral, such as cash, at a time when good collateral is scarce.”

GreySpark surveyed a number of organisations across the industry – including hedge funds, brokers and asset managers, on both the buy-side and sell-side – on their opinions regarding regulations that included European Market Infrastructure Regulation, Markets in Financial Instruments Directive II and Basel III.

The common consensus was that the impact of these regulations on liquidity risk was to be positive, with more than 75% of respondents indicating they believed liquidity risk would decrease in response to upcoming regulation.

If these regulations do have the effect of leaving some market participants with a shortage of collateral for use with clearing houses, some institutions will be able to take advantage and generate profits through collateral transformation, which is the process of converting non-eligible collateral into eligible collateral.

This takes the form of a clearing house member, generally large banks, receiving non-eligible collateral from a client, converting it into cash via repo and posting that cash with the CCP as collateral, which has been highlighted as neatly circumventing regulations on collateral quality.

“You can expect to see better-organised investment banks try to make money out of collateral transformation,” says Lake.

Misunderstanding of the potential effects of regulation could be linked to sentiment in the markets that guidance from regulators has been rather lacking, according to the GreySpark survey. In the report, no respondents characterised the level of guidance given by regulators as any better than “average”, with 34% of respondents deeming it to be “insufficient”.

The lack of guidance from regulatorsis also reflected in the lack of action taken by market participants in preparation for new regulations.

“Until regulators give more details, there’s unlikely to be much change," says Lake. "Regulators haven’t cottoned on to the fact that they need to be more prescriptive: they’ve traditionally taken a reactive approach, but now the industry wants to see a more proactive stance."