Buy-side optimistic on OTC derivatives reform – The TRADE poll

Institutional investors expect a positive impact from the migration of over-the-counter derivatives onto exchange, with 63% of respondents to November's poll on forecasting higher volumes.
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Institutional investors expect a positive impact from the migration of over-the-counter (OTC) derivatives onto exchange, with 63% of respondents to November's poll on forecasting higher volumes.

A quarter of respondents said that buy-side OTC derivatives volumes would decrease, with the remaining 13% predicting no change.

“I think the results are a reflection that the buy-side would welcome more transparency,” said John Jay, senior analyst at consultancy Aite Group. “But I think any volume increase is likely to be modest, perhaps between 10-20%.”

Tony Freeman, director of industry relations, EMEA at post-trade processing provider Omgeo, asserted that impending reforms to how OTC derivatives are traded and cleared could reignite a market that has stagnated since the financial crisis.

“I am not surprised that most respondents foresee growth in OTC derivatives once they are traded on exchange, and I would have possibly expected opinion to be even more strongly in favour,” he said.

Freeman said participation in the OTC derivatives market by long-only investors had declined substantially over the last couple of years, citing anecdotal evidence from one large fund manager that had reduced its participation by 90%.

According the Bank for International Settlements, the value of outstanding OTC derivatives contracts in June 2010 stood at US$582 trillion, almost US$90 trillion less than pre-crisis in June 2008 (US$672 trillion). This decline could mean market participants are not managing or hedging their risk in the most precise way.

OTC derivatives, particularly credit instruments such as collateralised debt obligations and credit default swaps (CDSs), were closely associated with the collapse of Lehman Brothers and AIG in 2008, and the market ground to the a halt as counterparty risk concerns gripped participants.

Omgeo's Freeman says the post-crisis characterisation of OTC derivatives as instruments of speculation has been exaggerated. Pointing out that CDSs only accounted for 5% of June 2010's total outstanding value, Freeman notes a “strong political element to the OTC debate”.

In the US, regulatory bodies the Securities and Exchange Commission and Commodities and Futures Trading Commission are in the process of drafting the rules that determine which OTC instruments will be traded on exchange and centrally cleared under powers handed to them by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Europe has taken a slightly different route and plans to implement new rules of OTC derivatives trading by the end of 2012. Regulations relating to central clearing and reporting of OTC transactions were included in the European Markets Infrastructure Regulation, announced by the European Commission on 15 September, with exchange-trading due to be addressed in MiFID II.

The requirement to switch trading of OTC contracts from a bilateral process is widely expected to lead to greater costs for buy-side firms.

Jay emphasised that some of these costs, i.e. those related to maintaining data and reporting standards and structural connectivity to new venues, will not be explicit and will have to be carefully monitored by buy-side traders. But he anticipates that the greatest cost will be in margining, as market participants will no longer be able to use their own discretion when deciding how much collateral to hold against a trade.

“If OTC trading is migrated on exchange, the rules around margining will apply consistently to all firms,” he says. “This could be a significant cost as companies will not only be required to hold initial margin, but also extra capital to insulate against market moves on a daily basis.”

While some have suggested these costs could negate the benefits of greater transparency of trading OTC derivatives in terms of valuations, most would see these reforms as necessary.

“The market saying it doesn't want OTC reform because of the associated cost isn't a valid excuse,” states Freeman. “Protection costs money.”

But with much of the legislation in the US and Europe still being drafted and finalised, the real shape of the OTC market at the end of 2012 remains very much in the balance.