Corporations’ struggle over the past half decade to keep pace with changes to the over-the-counter (OTC) derivatives market has nursed a growing desire for simplicity amongst participants in the market. These changes—largely the result of a global patchwork of derivatives rules, but also due in part to changes in accounting and valuation methods—have spurred a vexing new reality: Financial risk management has never been more complex.
As market participants prevail upon policymakers for much-needed regulatory simplification, we’re seeing the birth of a new era in which simplification in the derivatives market will be driven principally by private-sector efforts.
Last month in Lisbon, Portugal, at ISDA's 32nd Annual General Meeting of global derivatives market participants, an audience poll found that for 55 percent of attendees, regulation is the greatest concern for the year ahead, even though nearly seven years have passed since the Dodd-Frank Act was enacted.
After years of protecting derivatives regulations from revisions, policymakers now appear to be taking up the simplification mantle, with an eye toward cross-border harmonization and right-sizing of compliance obligations, especially for smaller market participants. Last month, for example, as part of its mandatory EMIR review, the European Commission proposed a number of simplifications to its derivatives rules. Among them are proposals to eliminate reporting obligations for corporates and clearing obligations for smaller financial counterparties. Meanwhile, in the United States, President Trump issued an executive order aimed at streamlining financial regulations, while Acting CFTC Chairman J. Christopher Giancarlo has initiated Project KISS—Keep It Simple, Stupid—intended to make CFTC rules and regulations simpler, less burdensome, and less costly.
Although policymakers’ efforts are necessary to shave the rough edges off of reform, we do not believe they will be sufficient, in part because the global regulatory infrastructure is so complex. In his opening remarks in Lisbon, ISDA’s CEO, Scott O’Malia, himself a former CFTC commissioner, highlighted the growing role of the private sector in this undertaking, noting that “ISDA wants to work with technology providers, process innovators, and lawyers to explore these new opportunities and create an environment where innovation and competition bring cost-effective solutions.” He pointed to data standardization, workflow improvements, and smart contracts as focal points for industry efforts.
Regulators also see a growing role for private-sector innovators in simplifying global markets. The CFTC’s Giancarlo last month announced a new initiative called LabCFTC that, among other things, “will be the hub for [CFTC] engagement with FinTech innovators.” Similarly, Patrick Armstrong, a senior risk analysis officer with the Innovation and Products Team of European derivatives regulator ESMA, recently spoke of the role of regulators in supporting innovation in financial technology and cost-efficient regulatory compliance. These public pronouncements reflect a keen understanding of the benefits of collaboration, rather than conflict, between government and the private sector in resolving industry challenges. This collaboration will be built first and foremost on a common understanding of the opportunities enabled by technological innovation and, further, by a commitment to ensure the regulatory framework evolves to ensure these opportunities can be captured.
Notwithstanding the importance of this shift in thinking, the vision of a simpler future is not expected to arrive as soon as the derivatives market might like. The vast majority of voting conference attendees in Lisbon (91 percent) believe that blockchain and distributed ledger technology (DLT)—which are widely expected to streamline regulatory processes like transaction reporting—will impact post-trade processes within three to seven years. Thus, while market participants appear to believe in the potential benefits of the technologies underlying blockchain, DLT, and “smart contracts,” they do not see those benefits materializing in the OTC derivatives markets in the near term.
As market participants endeavor to predict the future of this market, they remain uneasily rooted in a frustrating and costly present, wherein they have no choice but to contend with the complexity that the aftershocks of the financial crisis have foisted upon them. Users of derivatives undoubtedly will welcome the simplification and efficiency that can result from more effective collaboration between regulators and the private sector. However, such collaboration is in its infancy and will take years to evolve.
The changes produced by this collaboration, while likely to be beneficial over the long run, may bring with them further changes that must be analyzed and accommodated. But these changes, if and when they occur, will be of a happier sort, incrementally releasing market participants from some of the arduous challenges that have confounded them in the post-crisis reform era, and bringing with them benefits that for now are limited only by the imaginations of those who dare to envision them.
Matt Hoffman provides advice and solutions to corporate end-user clients of Chatham Financial, a global risk management advisory and technology firm in the debt and derivatives markets.
Luke Zubrod leads the firm’s public policy efforts and is a member of the CFTC’s Market Risk Advisory Committee.