Driving in the dark

As the buy-side prepares to deal with the new OTC derivatives trading landscape, the need to reassess three broad issues when it comes to trading partners – safety, connectivity and collateral – will mean that existing counterparties may not make the cut.

How much planning can the buy-side actually do right now when it comes to counterparty management? 

Although the basic principles of new OTC derivatives regulation are well understood, the fact that many of the finer points are yet to be determined means detailed assessments of brokers by the buy-side is still a bit tricky.

We all know swaps will be standardised where possible so they can be traded on exchange and centrally cleared, but institutional investors are still waiting for clarification on exactly which types of derivatives the new rules will cover, how trading venues will operate and detail on collateral requirements.

This work is currently being carried out by the Securities and Exchange Commission and Commodity Futures Trading Commission in the US and the European Securities and Markets Authority in Europe.

The reality is that with the rules scheduled to come into force by the end of this year, the window that the buy-side has to conduct detailed analysis of their relationships trading partners is slowly closing.

Surely some of this analysis must have been carried out already? What about the health of bilateral relationships after the financial crisis? 

Since the collapse of Lehman Brothers, monitoring the safety of counterparts for derivatives transactions has prepared the buy-side well for those exotic swaps that cannot be standardised.

These swaps will be subject to increased and more formal capital charges under the new rules.

More recently, the increasing number of banks that are being downgraded means many traditional investment houses that need to hold long-dated swap positions need to ensure the length of their exposures do not exceed the expected life of their counterparties.

The buy-side therefore needs to take a close look at data related to their counterparties, such as credit default swap spread levels, volatility of share price movements and the costs associated with replacing counterparties for long-duration swaps.

The cost of not monitoring counterparties was brought into sharp focus late last week as Goldman Sachs revealed that if its credit rating were cut by two notches it would be required to find an extra US$2.2 billion worth of collateral.

However, as we move into the new, clearable, world, it won’t just be about counterparty safety…

So what are the other counterparty issues? How much thought needs to be given to trading and connectivity? 

It may help to think of trading and connectivity aspects similarly to choosing counterparties for trading equities.

In Europe and the US, moving swaps on exchange also comes with fragmentation, with the new rules facilitating the creation of venues that will see liquidity split across a number of different markets. Your broker therefore needs to have connectivity to those markets – swap execution facilities in the US and organised trading facilities in Europe – that a buy-side firm requires. Again, the lack of certainty on what products will be eligible for clearing and the different products that trading venues will target makes preparation difficult.

Derivatives are also global products, and counterparts will also need to demonstrate an understanding when a trade falls under the US or European legislation.

Brokers will also need to manage collateral requirements in the new world – how does this change who the buy-side trades with? 

In addition to counterparty safety and ensuring that your broker is fit enough to handle margin requirements, buy-side firms could also make more use of brokers’ prime services, in particular their ability to offer collateral transformation services.

The need for collateral transformation – whereby a firm is able to substitute one type of asset for another in order to meet margin requirements – is becoming more important, particularly given that sovereign bonds that were once regarded as appropriate for meeting margin requirements are no longer considered as safe as they once were.

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