In the decade to 2008, nowhere did financial innovation quite run riot like the OTC credit derivatives markets. On the one hand, highly complex new products were developed to slice up and repackage credit risk, first collateralised debt obligations (CDOs), then CDOs2,CDOs3 and beyond.
On the other, back-office processes for these state-of-the-art financial instruments remained woefully 20th century. Anecdotal evidence suggests confirmations, for example, were rarely matched. More than in almost any other market, opacity and the pursuit of high margins triumphed over due diligence and process.
After Lehman Brothers and AIG collapsed, just over two years ago, OTC credit derivatives were blamed for the paralysis of the interbank markets; unsure of who was exposed to what through the OTC credit derivatives market, banks declined to lend to previously trusted counterparties.
Indeed, OTC credit derivatives were perceived as being so close to the epicentre of the global financial crisis that the September 2009 Group of 20 communiqué on market reforms called for “all standardised OTC derivative contracts to be cleared through central counterparties (CCPs) by end-2012 at the latest”.
Just over a year on and there is little agreement on the definition of standardised in the context of OTC derivatives. In December 2009, a paper published jointly by UK regulator the Financial Services Authority and HM Treasury, the UK finance ministry, declared: “In deciding whether a product is eligible for CCP clearing the sole criterion of standardised is insufficient and would leave CCPs and the market exposed to a number of risks.” Despite the progress of legislative reforms during 2010 to date in both Europe and the US, policy-makers have shied away from the task of identifying which OTC derivatives will be migrated on exchange.
In the US, the Dodd-Frank Act aims to shift a portion of OTC derivatives trading to public exchanges and mandate CCP clearing, but has left the specifics to regulators the Securities and Exchange Commission and the Commodities Futures Trading Commission. In Europe, the European Commission plans to move OTC derivatives to clearing via CCPs as part of a new European directive presented by its single market commissioner Michel Barnier on 15 September 2010.
Although the European legislation is currently under consideration by the European Parliament and member states – with the expectation that once adopted it would apply from Q4 2012 – the proportion of OTC derivatives affected will be decided by the European Securities and Markets Authority, the new powerful pan-European regulator that starts work at the beginning of 2011.
Buy-side market participants have already criticised the plans in Europe, on grounds that it would burden fund managers with increased costs, since central clearing would require the provision of fees to CCPs and clearing members that process OTC transactions as well as an initial margin payment. Evidently, the size of the cost burden on the buy-side will depend on the extent of the instruments affected. As the most frequently traded type of OTC instrument, interest rate swaps are almost certain to be targeted by regulators, but the fund managers' participation in this market may depend on their use of asset/liability management strategies.
Increased transparency is to be welcomed, but not at any cost. With the 2012 deadline barely 14 months away, pressure to grasp the OTC derivatives nettle will intensify.
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