OTC derivatives reforms to accelerate automation

OTC derivatives will be easier to price and trade by the buy-side following sweeping legislative reforms, but the sell-side’s appetite to supply them may decrease, according to industry observers.
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OTC derivatives will be easier to price and trade by the buy-side following sweeping legislative reforms, but the sell-side’s appetite to supply them may decrease, according to industry observers.

Following the collapse of Lehman Brothers and near-failure of US insurance firm AIG – both major players in the OTC derivatives space – regulators on both sides of the Atlantic are committed to increasing transparency and standardisation of OTC derivatives through a revised framework. According to the Bank of International Settlements’ bi-annual survey, the total notional amount on OTC derivatives contracts outstanding among the G10 countries plus Switzerland stood at just over US$604 trillion in June last year.

At the end of last year, the US House of Representatives approved a bill for revamping the OTC derivatives market, which will come under discussion in the Senate from 20 January.

In Europe, the new internal market commissioner for the European Commission Michel Barnier has prioritised reform of OTC derivatives law and the Commission has already started to draft legislation, which it expects to finalise during 2010.

Both the US and Europe are focused on four elements: the standardisation of OTC derivative instruments; the creation of central data repositories to monitor volumes and values; central counterparty (CCP) clearing; and execution of OTC derivatives on public exchanges.

While this introduces changes for both buy- and sell-side firms, the long-term benefits are expected to make traders’ lives easier.

“The automation that will result from standardisation of OTC derivatives will make it easier to get fair prices, as well as making it simpler to trade and clear them using electronic means,” Kevin McPartland, senior analyst, TABB Group and author of a recent paper titled ‘OTC Derivatives US Regulatory Update’ told theTRADEnews.com.

According to Anthony Kirby, director, regulatory and risk management, Ernst & Young, the standardisation of instruments brought by the anticipated changes may provide another business opportunity for the alternative trading venues that have flooded into Europe since MiFID’s introduction in 2007.

“The ease of access to multilateral trading facilities in Europe compared to the US means there is a real chance that they could open up their platforms to the buy-side for OTC derivatives trading,” said Kirby.

Kirby notes that MiFID in Europe went further than Reg NMS in the US in allowing the creation of alternative venues. According the Committee of European Securities Regulators, which promotes regulatory convergence across the region, there are 133 alternative venues in Europe, many of them derivatives platforms.

As well as easier price discovery, ongoing valuations will also be made simpler by automating more of the OTC derivatives trading process.

“The proposed reforms will make OTC valuations more straightforward as these can be obtained from CCPs instead of the counterparty you deal with,” said Tony Whalley, head of dealing and derivatives, Scottish Widows Investment Partnership.

Furthermore, Whalley explains that because ongoing exposure would be to a CCP rather than a broker, the buy-side may become more confident trading OTC derivatives and increase their use.

However, greater transparency and competition for standardised OTC derivatives prices will drive margins down for the sell-side and could lead to higher costs in other areas.

“The buy-side will have to manage the trade-off between the benefits of obtaining fair value pricing and reducing operational risk versus the real possibility that some sell-side players will become disincentivised to provide standardised products,” observed Kirby. “As a result, they may look to recover margins by encouraging clients to use the more complex OTC instruments.”

TABB’s McPartland also stressed the need for a convergent regulatory approach across the US and Europe, but said he fully expects there to be similarities between both sets of legislation.

“If one geography is alienated, it would throw off the balance of how these products are traded in a global market,” he said. “However, I think the ultimate approach will be similar to MiFID in Europe and Reg NMS in the US: two different ways of achieving the same goals.”

So far, the US is keen to put as many standardised products on public exchanges as possible, as well as favouring CCP clearing and position limits.

However, UK regulator the Financial Services Authority released a paper towards the end of last year arguing that standardisation of OTC instruments is no panacea and should be considered in parallel with other factors such as regular availability of prices and depth of market liquidity. It also suggested that position limits may not be fully effective in controlling manipulative market practices. Both Europe and the US have however agreed on the benefits of using central counterparties for standardised instruments.

In his paper, McPartland observes that OTC derivatives trading is quite robust, as he notes that 65% of OTC derivatives transactions – whether done bilaterally or using a CCP – were subject to collateral requirements in 2009. He expects this figure to rise considerably as a result of the reforms but warns that a blanket approach to clearing OTC derivatives through CCPs could cause more problems than it solves.

“Regulators will work with CCPs, but it is the CCPs that will need to have the final say on what can be centrally cleared,” said McPartland. “Clearing houses need to be able to accurately value these products and set the margin requirements accordingly. A very complex or illiquid product can make valuing difficult and create another type of risk.”