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Global interest rate derivatives: assessing the impact of new regulation

Publication date: 30 April 2012
Author: Greenwich Associates

Most of the corporate interest rate derivatives users participating in Greenwich Associates most recent Global Interest Rate Derivatives Study believe that new Basel 2.5 and III derivatives regulations in Europe and the United States will result in wider spreads in derivatives markets and ultimately increase their costs of capital. There is much less consensus that these new margin requirements and revised capital reserve requirements on banks will affect trading practices or hedging strategies.

Overall, a plurality of interest rate derivatives users think the new capital requirements regarding derivatives trading will have little to no impact on current practices, or do not feel they have enough information about the regulations to make a meaningful assessment. Of those that are concerned about direct and indirect consequences of the regulations, most derivatives users seem willing to absorb the impact of wider spreads without reducing their level of trading activity.

“It’s a much different story when it comes to margin requirements,” says Greenwich Associates consultant Andrew Awad. “A large share of study participants predict that the need to post collateral would cause them to reduce hedging activity and/or cut back their activity in interest rate derivatives.”

Impact of Bank Capital Rules

Many users of interest rate swaps know that at some point they will be required to trade through swap execution facilities (SEFs) in the United States and organized trade facilities (OTFs) in Europe. At present, however, uncertainty abounds about if and how new derivatives regulations will affect the specific hedging and trading practices of companies and financials in various markets. However, the implementation of Basel 2.5 and III by some leading banks around the world has resulted in higher credit charges to bank customers, increasing transaction costs for corporate derivatives users. The impact will be felt even more widely when the new Basel capital requirements are implemented by all derivatives dealers, which is expected to happen before 2019.

“The capital requirements may well have a more meaningful impact on corporate demand for derivatives than any of the pending regulations specific to derivatives,” says Greenwich Associates consultant Peter D’Amario.

New Issues Could Boost Sluggish Trading Volumes

Notional trading volume in interest rate derivatives totaled approximately $1.3 trillion in 2011, which is essentially flat on a matched sample basis in comparison to 2010 and follows a significant decline of nearly 20% the prior year. Derivatives trading volume from 2010 to 2011 was relatively stable in Europe, decreased in the Americas, and increased in Asia Pacific, with companies in each region respectively accounting for 61%, 23%, and 16% of the global total. Within Europe trading volume actually declined by approximately 30% in the United Kingdom while increasing modestly on the Continent. The U.K. decline comes in the wake of a 45% drop in trading volumes in 2010. Those global volume totals were rooted in a year of flat global corporate bond issuance and only modest growth in new fixed-income issues overall. “World bond markets are poised for a pickup in 2012,” says Greenwich Associates consultant Woody Canaday. “Corporate bond issuance in Q1 2012 is surging, and a sustained year-long rally would lead to increased derivatives activity among corporate end-users, albeit with some possible dampening as a result of new derivatives regulations.”

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