New over-the-counter (OTC) derivatives regulations in Asia will impose significant cost burdens on market participants, while the fragmentation of the region’s markets is expected to spur competition among clearing houses.
A report by consultancy Celent titled “Derivatives reforms in Asia” noted that a major implication of having centralised clearing in the OTC derivatives markets would be a higher cost of collateral management because central counterparties (CCPs) would be more conservative in their approach and set higher collateral and margin requirements. At present, bilateral clearing allows the counterparties to decide on the necessary collateral themselves.
“The cross-margining benefits that the larger participants currently derive from trading larger volumes might not carry into the new regime, and the CCPs are expected to be more cautious in this regard,” said Anshuman Jaswal, Celent analyst and author of the report. “The main problem with the Asian markets is fragmentation in terms of geography as well as regulations. Governments and regulators are coming up with different rules and regulations for their own markets. That means in accordance with those rules, each of them would set up their own clearing houses. Not all of these will be sustainable. So in the long run, markets like Hong Kong or Singapore could become the focus of derivatives trading in Asia.”
Central clearing would lead to significant IT and infrastructure costs for market participants in the leading Asian markets, Jaswal added.
“The connectivity requirements are going to increase, and it is going to be difficult for the smaller buy side firms and regional banks to create and maintain the infrastructure required to trade in the OTC markets,” he said.
He expects that leading sell side firms would try to meet buy-side requirements by providing this infrastructure as an additional service that would resemble the connectivity they provide for exchange-based trading and post-trade services. But once the infrastructure is ready and clearing is taking place on an ongoing basis, risk management and efficiency would improve for the OTC derivatives markets.
A Celent report released earlier examining OTC derivatives reform in Europe and the US suggested that some 10% of current global OTC derivatives volumes could be wiped out by forthcoming legislation.
Celent also pointed to the increased collateral management and margin requirements under Dodd-Frank as a major source of cost of buy-side market participants, estimating the cost of collateral across the main CCPs at US$1 trillion or higher. It also estimated total IT spend to facilitate the new rules alone could reach US$1.95 billion during the 2012-2013 implementation period and suggests tier-one banks can expect their initial expenditure to be within the US$150 million to US$300 million range in 2012 and beyond.
Regional nuances
In Asia, Jaswal expects the move to central clearing to play out differently from what is expected in the US and Europe where there are going to be large CCPs that will be able to harness economies of scale and attract global business. Domestic Asian exchanges or clearing houses are expected to create CCPs for OTC derivatives, which might have to deal with relatively small volumes and only local demand, Jaswal added.
The outstanding notional value of global derivatives at end-2010 was above US$560 trillion, while the gross market values of the global OTC derivates markets – which measure the cost of replacing all existing contracts – was around US$20 trillion. The estimated share of the Asian OTC derivatives market in the overall global outstanding is around 15% for both OTC equity derivatives and IRS, 2% for CDS, and 26% for OTC FX derivatives, with Japan contributing a majority of this volume.
Jaswal expects that 20-30% of OTC derivatives will not be centrally cleared. “These will be the bespoke or non-standardised derivatives that will continue to be cleared bilaterally. The cost of trading these bespoke derivatives contracts will become much higher because volumes will be lower and it will be much more difficult to find counterparties to trade these derivatives.
“Non-standardised derivatives also perform an important function in the market, but volumes will be much lower than before,” he added.
Tokyo and Singapore lead the way
In Asia, Japan and Singapore have taken the lead in setting up clearing houses for OTC derivatives such as credit default swaps and interest rate swaps. In November 2010, SGX Derivatives Clearing, Singapore’s CCP for OTC financial derivatives, began operations. The Japan Securities Clearing Corporation (JSCC) began the clearing of iTraxx Japan credit default swaps in July 2011 and is expected to begin clearing interest rate swaps soon, possibly in collaboration with a foreign CCP such as LCH.Clearnet.
The Hong Kong Monetary Authority (HKMA) will require financial institutions to report and settle their derivatives trades via a centralised clearing platform run by the Hong Kong Exchange (HKEx). The new rules will initially apply to trades in interest rate derivatives and non-deliverable forwards, because of their high degree of standardisation and systemic relevance, by the end of 2012.
Scott Shenk, director in prime services and head of Asia Pacific listed derivatives direct market access at Credit Suisse, said, “One regulatory requirement coming out of the US is that if an OTC swap is determined to be clearable, then it should also be made tradable on a SEF (swap execution facility). And that isn’t defined yet. There’s still uncertainty about what exactly it will entail and how long it will take to get out here. At this point, it is unclear how much it is going to affect Asian counterparties based in Asia versus counterparties in Asia that may have a parent in the US or UK.”
Toby Lawson, head of futures & options and cash equities executions, APAC, Newedge, added, “Japan and Singapore have had some success in setting up central clearing of OTC derivatives, particularly in the commodities space, where there seems to be a natural interest for clearing of OTC products. We’re also seeing a number of Korean companies using US clearing houses. So there’s been quite a bit of development in the commodities space.
“The major part of OTC business is in financial derivatives. The difficulty on the financial side has to do with cross-border issues, tax and regulations. Asia is far more complex in terms of establishing a central clearing function for OTC financial products. The challenge is how to resolve that to make it commercially viable for an exchange and the regulators would have to look at whether, say, if you want to have clearing of an OTC product denominated in your currency outside of the country, does that satisfy the regulator who would probably want those transactions to be booked onshore for tax reasons and also for control and regulatory reasons,” he added. “I don’t think there’ll be a central clearing house in the region. Each country will develop its OTC clearing as we’ve seen in Japan and Singapore.”
Endorsed by the Group of 20, Dodd-Frank aims to move as large a proportion of OTC trading activity as possible onto the newly-defined SEFs. The Dodd-Frank Act has been delayed from its original July target date, following the announcement by Gary Gensler, chairman of the Commodity Futures Trading Commission, in September that some of the key rules, including those related to SEFs, will not be implemented until 2012.
Sustainability challenge
Jaswal believes that due to smaller volumes, it would be difficult to sustain all the new clearing houses that will offer clearing across markets such as Japan, Singapore, China, Hong Kong, Korea, Taiwan and India.
“We expect that some of these new CCPs might not have sufficient volumes, and this will lead to consolidation in the Asian OTC clearing space,” he said. “Globally, the absence of interoperability standards and guidelines among CCPs could allow large derivatives players to maneuver clearing traffic to favored CCPs. This is expected to lead to higher costs and risks for the remaining players, and hence only some CCPs will remain viable after a few years.”
Jaswal also expects there to be some migration of volumes to exchange-traded derivatives due to the higher costs of trading and clearing in the OTC markets, and that innovative exchanges that can create suitable alternatives for OTC derivatives will be able to benefit from this phenomenon.
Shenk added, “What could be construed as very plain vanilla interest rate swaps with ‘standard’ terms and can be listed on the screen, there may be potential for those to end up on an exchange but exchanges around the world have in the past experimented with swap futures contracts with limited success, so it is unclear if that will be the model or not.”
Author: Jill Wong