FINCAD recently sat down with industry thought leaders, John C. Hull and Alan White to get their perspectives on the primary challenges facing market practitioners in the OTC markets. Both were in agreement that, in recent years, the largest hurdle has been a dramatic increase in regulation.
Before the crisis, the OTC Market was largely unregulated. But since then, a huge amount of regulation is making it harder for market practitioners to trade these instruments. “The interesting thing is that if you look at what composes the bulk of the OTC markets, it’s relatively straightforward interest rate swaps. These make up about 70% of the market,” commented Hull. “But interest rate swaps had nothing to do with the crisis. In fact, the interest rate swap market continued functioning pretty well throughout 2007 into 2009. So there is no real reason why interest rate swaps should be heavily regulated. But the reality is that they are.”
White was in agreement with Hull’s remarks around excess governance, which, he speculated, may eventually push trading of derivatives outside the US into Europe. “One could argue that the interest rate swap market is being regulated even more so than other products. It’s clear that the regulators want the banks to do a lot less derivatives business, and they’re pushing in that direction.”
Hull added, “In the US, the CFTC has been given responsibility for forming most of the regulations for the OTC Derivatives markets. Of course, the CFTC’s traditional mandate has been to regulate the futures markets, which is something they understand really well. Unfortunately, the CFTC tends to regulate swaps in the same way as futures, which is problematic given the two markets are very different. By doing this, the CFTC may actually be creating an environment where swaps do move offshore.”
Check out our video to get more of Hull and White’s thoughts on the hurdles facing practitioners in OTC markets.