The quest of governments for more secure financial markets, a
reaction to the collapse of CDO markets, the default of Lehman
and near default of AIG, is relentless, spurred on by the
ongoing economic slump and only mildly distracted by the
lobbying of concerned parties.
Right or wrong, the OTC derivatives markets have
been identified as one of the central parts that need reform.
The template for that reform, particularly in the US, has been
the ETD derivatives market, which performed well all through
the economic turmoil.
Dodd-Frank legislation in the US and EMIR and MIFID
II regulations in the EU are the means by which the OTC
derivatives markets are being transformed. Despite delays, the
US rules are expected to be in place at the start of 2012, the
EU at the end of that year.
If we use the currency split of the interest rate
(IRS) OTC derivatives notional outstandings as published by the
BIS as regional indicator, these two jurisdictions between them
cover more than 80% of the global OTC derivatives business,
estimated at $ 601 trillion outstanding notional amount at the
end of 2010 by the BIS.
So how will these rule changes impact the OTC
Firstly they will mandate that a large part of the
transactions will need to be cleared by a central counterparty,
similar to what has been the case in ETD markets for years.
Citibank in a recent study estimates that 90% of the OTC IRS
market (by far the largest of the OTC derivatives markets with
$465 trillion outstanding) will be clearable, 85% of the CDS
market, 75% of the equity derivatives and commodities market
and 55% of the FX derivatives market.
LCH recently announced that they will be able to
process 84% of all OTC IRS derivatives for clearing. The
estimates by other market experts are in the same ballpark, so
a substantial part of the OTC derivatives market will be
CCP Clearing will have a profound impact on the
market structure. No longer will counterparty credit quality be
a differentiator. Similar to the ETD markets, the playing field
will level out over time.
Other rule changes will contribute to this such as
increased pre and post trade transparency as a result of MIFID
II, non discriminatory access to SEF platforms in the US etc.
Punitive capital charges and daily bilateral margining
requirements for OTC derivatives not cleared through CCPs will
make it difficult to escape CCP trading.
One inevitable consequence of this development will
be commoditisation and the margin compression resulting from
To compensate processes, front, middle and back
office, will need to be streamlined. Is there still a need for
separate affirmation platforms or will trades be transferred
directly into the clearing house, as is the case for ETDs?
Is there still a need for ISDA agreements or are
these superseded by clearing agreements and rulebooks of the
CCPs? Currently this is not envisaged, but margin compression
and cost pressures will surely focus minds once the new markets
The other consequence will be an increase in
trading activity. To compensate for reduced margin, but also as
a result better transparency and less perceived risk, OTC
volumes are likely to rise. Market participants will have to
adjust their business strategy to this new world.
The levelling of the playing field is also likely
to result in the entry of new market participants, such as the
prop trading firms active in today's exchange traded
derivatives markets. Trading frequency will increase and
average notional sizes decrease.
Market structure, trading methodology and activity
as well as processes in the OTC derivatives markets will over
time increasingly resemble the practices in ETD derivative
markets. But will ETDs replace OTC derivatives?
I dont believe so. There is still demand for
flexible dates as opposed to the fixed dates of typical ETD
contracts. Closer integration of both markets will also
facilitate arbitrage between them, thus securing volume for
both. The OTC markets also tend to be ahead of the curve in
creating new products to satisfy specific needs. And central
limit order books may not be the right method to trade the more
illiquid OTC derivatives.
So will the markets converge towards the ETD model?
Definitely, but OTC derivatives will not go the way of the
dinosaur and disappear.
Christian Baum is a consultant at Riverdale