Finding the right match

A number of buy-side firms have begun picking brokers to meet their trading and clearing needs for the new OTC derivatives era, but what will be the most important factors driving counterparty selection?

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What is the buy-side looking for from their sell-side partners when it comes to OTC derivatives trading and clearing?

In the first instance, they simply want to find a broker that is actually willing to offer clearing and brokerage services for swaps after the new rules kick in.

The sell-side is bracing itself for a tough regulatory environment that will make it more expensive for them to fund balance sheet intensive activity. This could affect their ability to serve buy-side firms in the OTC space.

Because they trade in small volumes and pose a high risk, smaller buy-side firms may find it rather difficult to find accommodating sell-side partners.

The best option may be to rely on existing relationships with futures brokers to provide trading, clearing, and most importantly, collateral services.

Why is collateral a crucial element?

From brokers' perspective, this is the most capital intensive activity.

The new rules will require buy-side firms to post initial margin against OTC derivatives positions for the first time and deliver collateral to clearing houses on an intra-day basis - possibly up to six times a day.

The buy-side won't necessarily have the assets on hand to post to margin, or technology to meet the immediacy of the new environment. As such, they will initially rely on brokers to meet collateral obligations on their behalf, before paying them back at a later date.

This may include collateral transformation for those buy-side houses that are cash-poor or don't have a large inventory of sovereign bonds - the key assets that will be needed to meet margin obligations.

What should the buy-side expect in terms of execution?

The rules governing the trading of swaps on exchange-like platforms are still under discussion in the US and Europe, so its unclear how the final landscape will look. However, liquidity is likely to fragment, particularly for the more heavily-traded interest rate and credit derivatives, requiring brokers to have broad connectivity to as many venues as possible, as and when they emerge.

As it did for equities, technology to re-aggregate liquidity and trade across the different venues simultaneously is likely to emerge.

But while brokers will look to recycle the existing technological capabilities they have already developed for equities, achieving best execution will be trickier for derivatives. Swaps are typically traded less frequently and in bigger size compared to stocks and post-trade data is lacking, making meaningful transaction cost analysis tricky.

This will present an opportunity for data vendors to take up the challenge of standardising trade data from the various trading venues.

Analysis of trading performance in OTC derivatives will depend more than just on price.

The cost of clearing and an instrument's liquidity profile will be equally important and institutional investors may be looking for analytical tools that help them determine when to trade a swap or an existing listed derivative contract, based on these factors.