OTC derivatives transparency to hamper buy-side

Additional transparency in the over-the-counter (OTC) derivatives market, as envisaged by US president Barack Obama, could reveal more about buy-side trading intentions and expose dealers to greater market impact.
By None

Additional transparency in the over-the-counter (OTC) derivatives market, as envisaged by US president Barack Obama, could reveal more about buy-side trading intentions and expose dealers to greater market impact.

The reforms, announced last week, call for increased disclosure of trades and positions in OTC derivatives through more detailed recordkeeping and reporting. The planned tighter regulatory framework will also effect a migration of all ‘standardised’ OTC derivatives to exchanges or other transparent trading venues for centralised clearing.

According to Andy Nybo, principal and head of derivatives research at consultancy TABB Group, the new disclosure regime could be unfavourable for buy-side traders.

“Some market participants would argue there are circumstances in which they don’t want the details of a transactions to be communicated to the market at large,” Nybo told theTRADEnews.com. “If you are a large market participant doing a series of transactions and there is transparency, the market quickly becomes aware of what you are trying to do and it could be detrimental to future trades.”

Nybo suggests that reporting requirements can be drafted to serve both market efficiency and transparency. Regulators could mitigate market impact by introducing delays for some trades or limiting the information made public, for example. “There are ways to structure a reporting system that protects the interest of a particular strategy or trading firm, but that is a complex and convoluted process that will take time to develop,” added Nybo.

The proposed reforms follow the collapse of US investment bank Lehman Brothers last September, which hit many counterparties which had entered into derivatives contracts with the bank without central counterparty (CCP) protection. OTC derivatives are generally traded and settled bilaterally between two counterparties. Figures from the Bank of International Settlements put the notional amount of OTC derivatives contracts outstanding at the end of 2008 at $592 trillion globally.

The proposals’ overall impact on the buy-side could be limited. While derivatives such as interest rate swaps and credit default swaps have components that make them easy to standardise, the more complicated derivatives – those that use exotic currencies or have been specifically created to hedge a complex trade – may never be traded on exchange or centrally cleared.

Peter John, derivatives product manager at buy-side technology firm Fidessa LatentZero, said most of his clients generally use OTC derivatives – particularly the more complex and unique ones – as a way of generating alpha.

“Using this type of derivative is a cheaper and quicker way to get exposure to equities rather than bear the cost of holding an equity. It may not be possible to standarise these instruments in a way that is tradable on an exchange and centrally cleared,” said John.

A recent report from TowerGroup noted that migrating OTC products to an exchange could “excessively stifle innovation in the securities business” and that regulators would be faced with a tough decision on what can and cannot be standardised.

“Clearly, determining what gets traded on exchanges versus what remains in the OTC market is not easy for regulators and would require balancing the stability and safety of the exchange model with the innovation and customised benefits of the OTC market,” wrote Dushyant Shahrawat, senior research director, investment management, TowerGroup and author of ‘Dropping the Regulatory Hammer: Ten Impending Regulations in US Securities and Investments’.

However, some believe the move towards a more regimented regulatory structure could boost the confidence of the buy-side and its end-clients in simpler derivatives.

“These products are widely used and some have even been successful through the crisis, so having a CCP model and a more standardised way of doing things seems logical,” said PJ Di Giammarino, CEO of financial technology think-tank JWG-IT. “If OTC derivatives are standardised, a buy-side trader can present a stronger case to clients that these products are suitable and appropriate for them.”