Central clearing for OTC derivatives does not make for a safer market and may increase costs for end-investors, Barry Hadingham, head of derivatives and counterparty risk, Aviva Investors, has warned.
Speaking at the TradeTech Swaps and Derivatives conference in London yesterday, Hadingham called into question post-financial crisis reforms such as the G-20 commitment to standardise and centrally clear OTC derivatives. Prompted by host Anthony Belchambers, CEO of trade body the Futures and Options Association, who made a comparison between the costs of clearing at a central counterparty (CCP) and driving a Rolls Royce, Hadingham admitted expense was a serious hurdle for buy-side firms.
“Where the primary risk is counterparty risk, the CCP is the best place to manage that, but where the risk is directional, [i.e. exposure to the direction of movements in major market variables] then we have to seriously consider if the costs of clearing outweigh the benefits,” he said. “A lot of asset managers are saying it could simply be too expensive to operate in these markets.”
In Europe, the upcoming European market infrastructure regulation (EMIR) aims to standardise as large a proportion of current OTC derivatives as possible, so they can be centrally cleared. EMIR is currently being developed by the European Securities and Markets Authority, which has been assigned to detail some 30 technical standards so that the regulation can be implemented by the end of the year.
However, Hadingham believes that the new rules would create prohibitive costs in the form of default fund contributions, which would then be passed on to end-investors. He also suggested that CCP clearing may not remove systemic risk from financial markets as effectively as politicians and regulators hoped.
“It should be recognised that by moving into OTC clearing, we are moving counterparty risk around, rather than removing it completely,” he said. “Prevention is preferable to a cure. But I am concerned at what the final cost to neutralise risk will be once standardisation and central clearing takes effect.”
Belchambers suggested that with post-trade costs likely to rise as more contracts are brought onto central clearing, the economic viability of smaller, lower-volume asset managers continuing to operate in derivatives markets is being severely tested – especially given already depressed trading volumes and reduced revenues at many financial institutions.
“The costs don’t stack up in many cases,” he said. “The smaller firms will undoubtedly leave if they cannot justify the cost of continuing in this space.”
Cheap and cheerful
However, other participants at the TradeTech event suggested that OTC derivatives reforms would benefit market participants in the longer term. Jane Lowe, director of markets at the Investment Management Association, pointed to the benefits of increased standardisation as a means to promote more efficient, “cheap and cheerful” trading in derivatives markets.
“As commoditisation of OTC derivatives occurs, automation will increasingly reshape services and who provides them,” she said. “This reform will benefit all investors, while anonymity and standardisation of contracts can help boost liquidity. I see positive changes ahead.”
According to Lowe, market participants will have to either accept higher basis risk from using standardised derivatives contracts, or pay more for a bilateral contract that will provide a more exact solution. Under EMIR, bilateral OTC derivatives contracts will still be available, but will be subject to significantly higher margin requirements.
However, Ido de Geus, head of treasury and client portfolio management at Dutch investment management firm PGGM Investments, remained determinedly sceptical about the prospects for buy-side firms operating in derivatives markets.
“If clearing gets in the way of hedging risk, people will either go bilateral, or simply not use so many derivatives contracts at all,” he said.
While the deadline for EMIR implementation has been set for the start of 2013, as per G-20 commitments, Patrick Pearson, head of financial market infrastructure at the European Commission, revealed on Monday that the clearing obligation for firms in Europe will be delayed.