Regulatory Horizon: Hope and Change | Regulation of the OTC Market under Donald Trump
Regulatory Horizon: Hope and Change
Regulation of the OTC Market under Donald Trump
Whilst the Obama Administration’s rally cry of ‘Hope and Change’ resonated with voters 8 years ago, it signaled the beginning of the end of the status quo throughout the banking and financial service industries; and not coincidentally, annualized U.S. GDP growth above 3%. Namesake regulations were borne, and regulations to regulate those regulations ensued. The business of compliance boomed and the business of trading swooned. Net losses of millions of jobs around the globe drove stakes through the hearts of trading desks, operational support staff and numerous ancillary businesses and industries traditional to legacy sell-side market making business models. Borne were technology disputers, data management and mining initiatives, cloud infrastructures and armies of compliance and legal professionals; albeit, only fractionally offsetting the economic impact of lost higher wages across the front-office and related support functions.
Dodd-Frank, Volker, EMIR, Basel and numerous other pieces of regulation forced firms to overhaul, reduce or exit once highly profitable businesses. The opportunity cost mindset of the Obama Administration was to ensure, at all costs, an event like the 2008 Financial Crisis was not repeated. Toward the end of Mr. Obama’s term however, global regulatory bodies, perhaps acknowledging the pending seismic shift of change looming over the financial service industry, began to recognize and admit reform went too far to the detriment of markets, participation and prospects for robust economic growth.
Under the Trump Administration the United States will Lead
While the Basel Committee finally came to its senses at the end of 2016 with regard to relaxing punitive capital regulations, the incoming administration in the United States has not been shy about letting the world know reforming 2008 Financial Crisis borne regulations will be tops on its agenda for change. And while there remains much uncertainty about what the regulatory landscape will look like 12-18 months from now, I’ll present what I feel are highly likely outcomes and corresponding market, participant and foreign government and regulatory authority responses.
The First Order of Business
With an across-the-board control switch from Democrats to Republicans in Washington complete, a simplistic less is more approach will be undertaken by the new administration. Mr. Trump has called for an initial two prong approach to addressing regulation consisting of a moratorium on any new, non-essential rules and a by-federal agency review and identification of all restrictive to growth/nonessential regulations. Additionally, House Financial Services Committee Chairman Jeb Hensarling’s CHOICE Act may provide a blueprint for what’s to drive regulatory infrastructure moving forward.
H.R.5983 – Financial CHOICE Act of 2016
Introduced on September 9, 2016, Jeb Hensarling’s Financial CHOICE Act consists of a number of measures, intended to stimulate growth while rescinding authority and reach of federal agencies and regulation.
The CHOICE Act of 2016 amends the Dodd-Frank Wall Street Reform and Consumer Protection Act, among other Acts, to:
- repeal the "Volcker Rule" (which restricts banks from making certain speculative investments);
- amend Title II of Dodd-Frank;
- with respect to winding down failing banks, eliminate the Federal Deposit Insurance Corporation's orderly liquidation authority and establish new provisions regarding financial institution bankruptcy; and
- repeal Title VIII of Dodd-Frank; the bill removes the Financial Stability Oversight Council's authority to designate non-bank financial institutions and financial market utilities as "systemically important" (also known as "too big to fail"). Under current law, entities so designated are subject to additional regulatory restrictions. Designations made previously are retroactively repealed.
- provides for Community Bank and Credit Union Regulatory Relief as Dodd-Frank disproportionately burdens smaller financial institutions and credit unions via its one-size-fits-all methodology;
Certain banks may exempt themselves from specified regulatory standards if they maintain a certain ratio of capital to total assets and meet other specified requirements; the Qualifying Capital Election
The bill also amends the Consumer Financial Protection Act of 2010 to:
- restructure the Consumer Financial Protection Bureau by replacing its director with a bipartisan commission;
- subject the commission to the congressional appropriations process, expanded judicial review, and additional congressional oversight; and
- limit the commission's authority to take action against entities for "abusive" practices.
In addition, the bill:
- modifies provisions related to the Securities and Exchange Commission's managerial structure and enforcement authority;
- eliminates the Office of Financial Research within the Department of the Treasury;
- revises provisions related to capital formation, insurance regulation, civil penalties for securities laws violations, and community financial institutions;
- scales back the Federal Reserve’s regulatory and supervisory authority, subjecting it to increased congressional oversight and accountability while utilizing a rules based approach to the deployment of monetary policy; and
- holds financial regulators accountable to explain, justify the costs of and receive Congressional approval (regulations having an economic impact of $100mm or more) for any new regulation
Clearly less is more and accountability is king. And while I disagree in that certain covenants of CHOICE, such as setting a “10% leverage ratio and CAMELS rating of 1 or 2” bar in order to achieve numerous aspects of regulatory relief (i.e. the Qualifying Capital Election), from Section 165 of Dodd-Frank or Basel III capital and liquidity standards for instance, don’t go far enough at the onset, debate, comment and the legislative process would likely water down this conservative bar to something more palatable (the negative impact to hiring and lending as a result of the capital raising that would need to take place in order to meet the 10% leverage ratio by the 10 largest banks in the world would eliminate any economic benefit of being subject to less regulation), it’s a welcomed starting point. As is finally holding authors of regulations and regulatory agencies accountable.
Regulation of the OTC Market under Donald Trump | OTC Derivative Market Impact
With the end of Volker, comes the end on erring on the side of caution for the dealer. Regulatory fines sky rocketed under the Obama Administration as did the cost of capital. Sadly, it has become more profitable for banks to not extend liquidity and trade than the converse. This change has resulted in a remarkable drain of liquidity, particularly across OTC derivative markets. True, new entrants have picked up some slack, but the aim of regulation intended to reduce bank’s market profiles in OTC derivatives while increasing the base of non-bank participants simply hasn’t panned out – and it’s been to the detriment of the participant whom regulatory reform was intended to benefit. Therefore a repeal of Volker will provide a much welcomed boost to liquidity in FX, Equity, Rate and Credit derivative markets – at a time when its likely going to be needed most. In lockstep with reigning in the Federal Reserve’s ability to deploy market manipulating rhetoric and policy, a rising rate environment as a function of stimulative fiscal policy, the CHOICE Act’s repeal of Volker will be overlaid onto resumptions of normalized credit cycle ebbs and flows – a major stimulant to OTC derivative market growth.
What’s good for some may not be the case for others however. While it’s true that JPMorgan and Citi have stated no plans exist for a resumption of proprietary activity, the forces of competition within the market may throw caution to the wind and almost force legacy firms to increase proprietary trading as a function of increased market making. If those firms opt to not loosen the spigot, legacy OTC derivative competitors Morgan Stanley, Barclay’s or Bank of America will be lurking in the wait, just ahead of eager disruptors in Citadel, DRW or SIG. So this reform is likely to usher in, and force ‘re-participation’ by firms who had been regulated out, or to the sideline of providing liquidity to clients. Clearing is likely here to stay but alternative clearing solutions such as CMEs recently proposed ‘hybrid sponsored access model’ may struggle to gain traction as the cost of capital descends. What is almost assured is that more clearing clients will be onboarded, prime brokerage franchises will resume growing and consolidation amongst etrading platforms will accelerate.
Not quite akin to the cheapest-to-deliver, the Euro Zone would be forced to amend mirroring aspects of EMIR, MiFid and PRIIPS regulation; or it will find itself at a significant competitive disadvantage to the United States. To that end, Brexit may prove to be a boon for the United Kingdom; a region which should be able to more quickly and nimbly align itself with a more competitive financial service industry infrastructure across the pond once separated from the Euro Zone. Simply, I’d expect a domino effect to take place around the globe lead by the U.S., the U.K. and the Euro Zone; as regional regulation takes cues from the most advanced economies and the extraterritoriality footprint from Dodd-Frank, and later EMIR shrinks.
James Parascandola has more than 10 years credit derivative trading experience in buy & sell side roles and is presently an advisor to OTC derivative market participants assisting firms in navigating the most complex and high regulated environment in financial markets history.