They’re calling it the “Walkie-Scorchie,” or “Fry-Scraper,” but to local businesses it’s anything but funny. The new 37 story building going up at 20 Fenchurch Street in London’s financial district is a sight to see, with unusual concave shaped windows and more space on the upper floors than on lower ones. The radical design is instantly recognizable in the London skyline, but tourists are drawn to it not so much to marvel at the architecture as to witness a now undeniable phenomenon: The building can produce a “death ray” of light so hot that it has started fires and melted cars unfortunate enough to be parked in its path.
As it turns out, for two to three hours a day when the sun is brightest and hottest, the windows reflect and focus sunlight with such intensity that temperatures have been recorded at over 230F (110 C) at points below. When you recall that water boils at 212 F (100 C) you begin to realize the problems this light beam can cause for businesses, vehicles, and people in its path. As the autumn sun begins to set lower the phenomenon is expected to wane, giving the builder’s some time to mull over a permanent fix before the summer sun returns. In the meantime, they have erected a screen to diffuse some of the light, and closed off several parking spots that have come under fire (pun intended).
How could a building, presumably benefiting from centuries of architectural innovation, evolution, and best practice design, be configured in such a way as to be harmful to the surrounding community? In this day and age! To be sure, the design is not accidental – it’s a key feature and signature element of Uruguayan architect Rafael Vinoly’s contemporary style. He wanted to build a structure with dazzling brilliance, but surely not to the point of burning things! Not surprisingly, we at Chatham see many parallels to derivatives regulation, a similarly well-intentioned, half-completed venture already impacting banks and businesses below. Designed to increase transparency and contain systemic risk, regulation has nonetheless impacted end users of derivatives in ways that are at times quite burdensome and costly, with key provisions yet to play out in full. Here are just three of those areas causing concern
Transparency (for transparency’s sake?). Even staunch critics of derivatives regulation can agree that Dodd Frank has opened the door to more information than ever before. Already, one can go to the CFTC website and find the list of registered swap dealers (SDs), designated contract markets (DCMs), derivatives clearing organizations (DCOs), swap data repositories (SDRs), and provisionally registered swap execution facilities (SEFs). For those with a conspiracy theory mindset, you can also find out who met with whom at the CFTC, and on what date and regarding what broad topic. A treasure trove of new information is available to market participants and regulators on the SDRs themselves, as reported trades offer a glimpse at volumes within OTC derivative categories for the first time. How can this possibly be bad? A better question might be, “How can this possibly be used?” Recall that as a hallmark of this regulation, transparency is intended to help regulators see the market interconnectedness and know the magnitude of developing problems in real time. And yet, for all the new structures and visibility, the market is fragmented in ways that are proving difficult to gather meaningful information. How can regulators avert the next crisis if they have to query multiple platforms to see a crisis in progress? Do they even have the right information to make such a judgment? With transparency comes a new responsibility to sew together market information in ways that will prevent, not obscure, the next crisis. Transparency just for the sake of it can give a false sense of security and blind us to a future crisis.
Still Under Construction. Three years have gone by since enactment of Dodd Frank legislation, with much still left to do. Like the new building going up in London’s financial district, the derivatives rulemaking under Title 7 of Dodd Frank is similarly half done, with over 45 rules yet to be completed. But we can nonetheless see the outline of the building on the horizon, and witness the impact of such a huge new structure on the marketplace. Key features are already present, such as the clearing mandate and the end user exception from central clearing. The predominant derivatives clearing organizations (DCOs) are reporting consistent growth of cleared derivatives, leaving fewer and fewer transactions strictly over the counter. But other key features remain under construction, such as swap execution facilities (SEFs) and margin for uncleared derivatives. While we can make out the outlines of these new features, the infrastructure and utilities are not yet in place. Will they be thoughtfully finalized and implemented, or will they scorch market participants in ways as yet unforeseen? It is expected that OTC derivatives will, by design, become more expensive, as regulators seek to incent market participants to move more derivatives through clearing venues. We still need several years to see these and other remaining key features play out to know the full impact, but it is already clear the derivatives marketplace is vastly changed by the presence of this new Dodd Frank structure, even half built.
Unintended Consequences. No building built today could ever be planned and erected in isolation. The impact on and interaction with neighboring structures, transportation networks, and energy grids, must all be carefully considered with a project the size of 20 Fenchurch Street. Even then, as the “death ray” issue shows, some serious design flaws can surface that must be resolved for a project to co-exist in harmony with its neighbors. With Dodd Frank, some of this pre-work did happen – legislators and their fellow committee members were generally receptive to ideas from market participants – but the agenda of preventing the next financial crisis was, at times, at odds with making the market more friendly and accessible to derivative end users. The heavy hand of regulation that falls on swap dealers and other newly registered market participants is no less burdensome to everyday businesses who just want to manage interest rate, currency, or commodity risks. Businesses will bear the costs of this regulation – through higher transaction fees, capital charges, protocol adherence, and registrations (think LEIs), and compliance resources. It does us all no good if the weight of these added costs is sufficient to compel businesses to take otherwise undesirable risks themselves and forgo hedging. Clearly, our regulators no more intended to make a derivative “death ray,” any more than the architect behind the “Walkie-Scorchie.” And yet, when there is clear evidence that your building can burn or melt the surroundings, regulators must put up the screens and correct course before they burn down these vital risk transfer markets.
Derivatives regulation has the potential to exact positive changes on the market and make it safer and more transparent, but it could also make it more difficult and costly for end users to hedge in the process. Chatham has been working to be a force in easing many of the burdens created by regulation. The key challenge for regulators will be to harmonize the essential priorities of risk mitigation and transparency with the equally important need for efficient functioning for end users.