In the military they call it “mission creep”, when a campaign expands well beyond its original objectives. Goals begin to shift, and the resulting mission may look nothing like what was originally intended. To say that Thanksgiving shopping is experiencing mission creep is an understatement. Retailers, seeking a leg up on the competition, began to experiment with an earlier start to the holiday shopping season, and midnight of Thanksgiving became the new battle line. Ever emboldened to make the most of Black Friday, retailers like Wal-Mart, Sears and Target then shifted the line towards 8PM, figuring most turkeys had been cooked and consumed by then, and shoppers were surely ready for some spending action. Now, the front line has shifted yet again, as Retailer Kmart announced a 6AM opening on Thanksgiving. Black Friday, as it were, is now Thanksgiving, the day we give thanks for the bounty before us in the form of the latest gadgets, trendy clothes, and shiny new appliances.
But Kmart and others who have crossed this “no shopping before Thanksgiving” line are indeed walking a fine line between accommodating consumer demand and upsetting their customer base. Shoppers apparently do have consciences, and recognize that the clerk or checkout person helping them is not just an employee, but a real person who may be missing out on time with his or her family on Thanksgiving. A backlash movement is already afoot whereby consumers pledge not to patronize stores that early. Two questions come to mind on hearing this. First, where does principle end and consumerism begin? Retailers seriously want to know the optimal start time, to maximize sales without creating a frustrating dilemma for their customers. Second, what on earth does this have to do with derivatives? Mission creep, it turns out, is not confined to the military, or retail shopping, for that matter. Certain activities introduced under Dodd Frank may also find their way into your life and could come sooner than you think, even if you were not the intended target of these activities. But rest assured, market participants are likely still able to shape adoption despite regulator preferences.
Central Clearing. The ability to opt out of central clearing is preserved in the rule making thus far, for banks less than $10bn in total assets, and most derivative end users. Central clearing is the primary mechanism by which parties to a derivative transaction are able to mitigate their counterparty risk. This is indeed a real benefit, especially when one appreciates that most hedgers are looking to lay off risks. Along comes central clearing of OTC derivatives, and each participant’s counterparty becomes the central clearing house in the process. For large market participants with significant volumes, central clearing has been beneficial in certain ways, but smaller market participants would find little value in this relative to the cost. That is to say, unless costs come down, or other benefits materialize to “add value” to a process only mandated presently for the big players. Mission creep in central clearing would mean that more parties to derivative transactions would be compelled to clear their transactions, even if not mandated to do so. Fortunately for most derivative end users, this is still very much a choice, and if it comes to pass that it makes sense financially to do so, then this type of change could one day be welcome. But there is also a chance that it comes to pass because OTC uncleared swaps are made to be cost prohibitive, and if that is the case then backlash could ensue. Swaps will become more expensive as a result of Basel III capital requirements and also funding charges associated with initial margin imposed by swap dealers. The key question is whether such increases will be so material as to dissuade the use of the uncleared OTC derivatives market. This is one area to watch annually to see the extent to which market participants are choosing clearing because of regulatory incentives gone awry.
Swap Execution Facilities. With the advent of swap execution facilities (SEFs), if a swap is made available to trade on a SEF and subject to the clearing mandate, then it becomes a “Required Transaction” and must be traded on a SEF for those same constituents. SEFs could be a game changer for trading OTC derivatives but, in the interest-rate product class, SEFs will likely for some time be the venue of choice only for those market participants that are required to centrally clear their derivatives trades. Still, if you are an OTC derivative end user or a small bank that is not required to clear, you will want to keep an eye on the progress of this market place. With almost twenty provisionally registered SEFs, the key to each one’s survival will hinge on attracting deal flow. For certain interest-rate SEFs, one consideration might be the ability to trade uncleared swaps (interestingly, certain SEFs that are trading FX products are already trading those products on a bilateral, uncleared basis, since FX products aren’t yet subject to the clearing mandate). Just as retailers push the limits every shopping season on the new normal, SEFs will likely work towards welcoming all derivatives on their platforms one day. Mission creep in this case could also be a welcome change, if in fact end users have more flexibility in deal execution and especially if this could save on hedging costs or improve straight-through processing down the road. As with central clearing, though, the change would likely be unwelcome if participants are drawn to SEFs because their bilateral trading relationships have gotten too expensive in the process. Moreover, regulatory requirements at present would subject end-user trades to the same set of regulatory constraints as apply to financial entities – a limitation in flexibility that may limit adoption of SEFs by end users. For example, end users that transact on SEFs would at present need to ensure at least two (and eventually three) dealers are given the opportunity to quote, even if the end user might prefer to transact with a specific swap dealer.
Affirmation Platforms. The least innocuous aspect changed by Dodd Frank thus far may be trade affirmation. Affirmation is the process by which trades that are intended to be cleared are first confirmed by the parties to the transaction. It is the electronic equivalent of a paper trade confirmation. With the need for quicker response times to confirm trades subject to clearing, affirmation becomes an efficient process that has the necessary attention of the parties and the connectivity to move the trade quickly from OTC-executed to the cleared transaction. Affirmation is not required or necessarily even supported today for trades that would remain uncleared. But that could change as dealer counterparties nudge the affirmation platforms to support expanded services, out of a desire to whittle down their own unsigned confirms backlog. Electronic affirmation of all OTC trades may very well be a desirable form of mission creep, but only if market participants are compelled to do so by seeing the benefits of a quick reconciliation process and trade acknowledgement, and not due to cost or compliance considerations.
Just as retailers need to strike the right balance between holiday shopping kickoff and customer turnoff, so too regulators and swap dealer counterparties will need to strike the right balance between usefulness and forcefulness when it comes to the new process for executing, affirming, and clearing OTC derivative transactions. Once the first wave of “required” users moves through the process, a subsequent wave of “elective” users will follow if it makes sense financially and if the process is beneficial. We continue to help clients navigate the evolving process and establish a new normal, mindful that managing business risks is still the primary objective. Let us know if we can help you.
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