Friday, June 25, 2010

The Words "Can" and "Worms" Come to Mind

The U.S. financial regulation reform bill (called 'finreg' for reasons I don't care to know) seems to be all over bar the shouting, which of course began immediately on CNBC on Friday morning. The crux of criticism appears to be that the banks will - GASP - have to retain enough capital to cover their own losses in future. (Have they not heard of Basel II or III?)
The more draconian rules that impact capital markets players - with regards to proprietary trading, hedge funds and swaps trading - were greatly watered down in order to get a deal through. The Volcker Rule was shaved to allow banks to continue to invest in private equity and hedge funds, albeit on a very limited basis. But it is far from its Glass-Steagall roots.
Vanilla over-the-counter derivatives will be required to trade on exchanges and to be cleared, with bespoke OTC having to report central repositories. There are new margin and capital requirements. And banks will only have to spin off some of their riskier derivatives into subsidiary companies, leaving interest-rate and FX swaps in-house. No major surprises.
Which begs the question, was it worth all the trouble? I think it was - and it wasn't.
I like the fact that the big banks, hedge funds and prop trading firms are now aware that they are being watched. The days of free market for all, and damn the torpedoes full speed ahead, are over. The regulators will pick up the ball once the bill is signed into law, and - in theory - will understand how to make the rules stick. (This of course depends upon whether they stop acting like government employees, i.e. not just surfing naughty websites while their pensions mature).
I don't like the fragmentation that spinning off affiliates for swaps and OTC trading will create. Risk managers will have a nightmare trying to gauge risk and maximize capital across not just asset class silos in-house, but across subsidiary companies that are taking large positions.
It could be that the new regulations open up many new cans of worms. I feel certain that the banks and big trading companies are already figuring out how to game the new rules, that is what they do after all. There are always new opportunities to be found with new regulations. At the SIFMA conference a group of analysts discussing the impact of financial regulation on technology mentioned one.
If derivatives are to be more widely traded on exchanges, they will be eligible for high frequency and algorithmic trading. This means the margins will shrink (it is already happening with energy futures, a major oil company tells me), as will profits. Transparency does not come without costs. This means players will have to create more complicated bilateral OTC deals in order to make money. Or move away from the U.S.. My bet is that both will happen.

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