Market participants gearing up for widespread changes in the OTC derivatives market are likely to favour exchange-traded products to manage risk because of onerous margin requirements for exotic instruments.
The predictions are part of new research from consultancy TABB Group commissioned by the World Federation of Exchanges and suggest that a margin shortfall for swaps that reached US$2.6 trillion at the end of 2011 could be reduced to several hundred billion dollars based on product selection changes.
“A war is being waged between forces of the status quo and forces of transformation of the global risk transfer market,” says Paul Rowady, senior analyst at TABB and author of the study. “It has the potential to shift product selection for hedging and trading purposes, from exotic and bespoke trade structures, to standardised and clearable swaps, futures and new futurised/hybrid swaps.”
The research focuses on the core changes that will result from the new OTC derivatives regulation such as clearing, margin, automated trading, costs, reporting and extraterritoriality and compares them with global exchange-traded derivatives markets.
The reforms will standardise OTC derivatives where possible so they can be traded on exchange-like platforms and cleared by central counterparties, thereby subjecting them to more formal margin requirements. Exotic products that are not suited for exchange trading will be subject to higher margin costs.
TABB estimated that the OTC derivatives market reached a record US$709 trillion of notional values outstanding at the end of December 2011, but added the exchange-traded derivatives market remains larger, accounting for 55% of the overall risk transfer market.
“To mandate clearing and margin requirements during an era of deleveraging – when collateral becomes painfully scarce – is a bitter pill to swallow for many financial entities,” said Rowady. “These margin requirements may continue to make exchange-traded and other standardised products more attractive.”
But he added that enforced clearing and the mutualisation of risk are more desirable than the consequences and costs that could arise if a major derivatives player collapses.
Trading venues take shape
Another study from capital markets research firm Greyspark examined the environment for the newly-created derivatives trading venues that will emerge as a result of the new rules.
In the US, the Dodd-Frank Act included the creation of the swap execution facility, while in Europe, MiFID II will likely introduce derivatives trading venues via the new organised trading facility category of trading platform.
With over 50 firms planning or launching trading venues for derivatives, liquidity aggregation – particularly in a low volume environment – will be key.
According to the report, aggregation must include an accurate valuation process for products, a reliable estimate of the size of firm and executable liquidity available, and an optimisation of the trading costs.
The report also highlights the differences that face buy-side firms as they opt to either connect to trading venues themselves – which potentially increases costs through the need to set up market access and clearing infrastructure – or access derivatives venues using existing relationships with dealers.