Greater transparency in the OTC derivatives market is a fundamental aim of regulators looking to decrease systemic risk in this market, but a number of reports have highlighted that achieving this goal will come at a cost for the industry.
The G-20 inspired reforms to OTC derivatives in the US, Europe and beyond, will, where possible, require swaps to be traded on exchange-like platforms, reported to a central securities depository and cleared through a central counterparty. But while greater transparency may help to improve clarity, it clearly carries a cost. Research firm TABB Group estimates the extra cost of clearing at US$2 trillion for interest rate products alone.
That could be a problem for both buy- and sell-side firms struggling to balance their books in the face of multiple concurrent global reforms. A paper by trading technology vendor Fidessa, ‘For whom the bell tolls’, highlighted some of the difficulties faced by market participants attempting to comply with the new regulations.
“Coming at a time when Basel III is increasing capital adequacy ratios anyway, the cost of capital has never been higher,” said Steve Grob, director of group strategy at Fidessa and author of the report. “In fact, it’s doubtful whether there is enough high-quality collateral available if all the OTC trading that exist today were to be centrally cleared.”
Collateral costs were also pinpointed by TABB Group as a potential stumbling block. The TABB paper, ‘Optimising collateral: In search of a margin oasis’, states that while buy-siders largely expected that their brokers would assist with any shortfall through collateral transformation services, this will not happen in practice due to sell-side reluctance to take the balance sheet hit this would entail. Instead, the research suggests that collateral will become increasing scarce both in Europe and in the US – forcing investors to carefully consider how they use their available resources.
Buy-siders will need to invest in collateral optimisation technology and services, spend on new technology and restructure internal processes to become better organised and more efficient, suggested TABB. Firms that don’t will be hard pressed to survive.
Meanwhile, Thomson Reuters carried out a survey of buy-side institutions across 30 countries, titled ‘Bridging the transparency gap’, which revealed serious concerns about the quality of market data and market transparency that institutional investors currently have access to.
The Thomson Reuters survey found that nearly half (48.5%) of respondents want more transparency into the underlying information about the pricing vendors’ offerings – suggesting that investors are still not satisfied they have the clarity on pricing to ensure they are getting a good deal on their OTC derivatives transactions. Rated as the top concern by 75% of respondents, data quality trumped risk management (47.9%) and cost cutting (29.2%).
“Pricing vendors need to do a better job proactively by reaching out to their customers and pushing information to them rather than putting the onus on the client to pull down information,” said Jayme Fagas, head of evaluated pricing at Thomson Reuters. “To address transparency, we see a new information sharing dynamic developing as part of the operational processes at our clients’ firms.”
Aside from the cost of transparency, some investors remain concerned that the shift to central clearing may disadvantage long-term investors from a risk perspective in any case. According to Grob at Fidessa, buy-side firms could face increased risk by having to trade with unknown counterparties on centralised platforms.
“Some large buy-sides can prefer the bilateral model, particularly if they only trade with other large institutions that are similarly risk averse and well capitalised,” he said. “For them, centralised clearing is potentially riskier as they don’t know which other firms their margin is being combined with, or the credit ratings of these firms.”
Some observers also fear that CCP competition could also prompt a flight to the bottom on margin, reducing the quality of risk control, while market participants should expect to pay more for smart order routing and algos as liquidity spreads between multiple venues.