Market participants and clearing infrastructures will have to adapt to near real-time clearing of OTC derivatives within the next three to five years, according to a study by financial research consultancy TABB Group.
“Real-time clearing of a broad range of OTC products will happen,” said Kevin McPartland, TABB principal, director of fixed income research and co-author of the report. “Market participants and regulators demand it, and innovative technologists guarantee it.”
The report envisions a change from T+10 clearing, which was until recently the norm for some OTC products, to T+0 so that counterparty exposure becomes more manageable. Faster clearing would also lead to more efficient collateral and inventory management, freeing capital and lowering margin requirements.
Prompted by regulatory changes under the Dodd-Frank Act in the US, which seeks to bring as large a proportion of OTC derivatives volume as possible onto newly-created centrally cleared platforms called swap execution facilities, and by MiFID II in Europe, which also seeks to centrally clear OTC derivatives, clearers will face massively increased transaction volumes. TABB Group estimates a twentyfold increase in transaction volumes and a quadruple increase in market data volumes.
Building out the infrastructure at global dealers and clearing houses to handle the increase will be difficult, says the report, potentially providing opportunities for third-party technology providers to step in – especially since Dodd-Frank requires trades be reported “as soon as technologically possible”.
Moreover, the changes will force more complex products into the clearing environment. Portfolios that once contained only OTC derivatives products will now contain a mix of both cleared and non-cleared trades. This will create risk-management issues for buy-side firms, dealers and clearing houses, says the report, as calculating margin will become more complicated than before. At worst, the cost of moving to central clearing will result in market participants having to raise US$2 trillion to cover the initial margin.
Cross-asset clearing and margin netting are expected to become key parts of the central counterparty (CCP) value proposition, as market participants try to conserve capital. The offset from margin netting at the clearing level can amount to 99% in some cases, according to previous TABB Group research, but with multiple clearing houses and portfolios split between the cleared and bilateral worlds, the costs are still likely to be substantial.
Capital markets research firm Woodbine Associates also released a report this week which suggested that, under the Dodd Frank Act, US market participants could face substantially increased costs from margin requirements for non-cleared trades, equal to between 140% and 200% of the level a CCP would require for a generic transaction with the same risk characteristics. This would particularly affect end-users who require an exact hedge for their business-related risk, but would be unable to gain this from other sources.