The need to temper the risks inherent in the over-the-counter (OTC) derivatives market was regarded by many as a necessity following the recent financial crisis, but will proposed reforms limit the effectiveness of these products to the buy-side?
Reforms are under way on both sets of the Atlantic, with Gary Gensler, chairman of US futures regulator the Commodities and Futures Trading Commission, and European single market commissioner Michel Barnier repeatedly reaffirming their support for a more transparent and competitive OTC derivatives market.
Bringing these products on exchange requires coordination between the US and Europe, which both Barnier and Gensler have committed to. But the division of OTC products into those that can be standardised and traded on exchange and those that should remain OTC is far from straightforward. It could also affect how and whether buy-side firms use derivatives in the future.
The first consideration will be cost. Exchange trading and clearing of OTC derivatives will lower credit and counterparty risks, but will also require a larger amount of collateral to be submitted by buy-side firms.
But OTC costs may also rise. Regulators are likely to insist on higher levels of capital to support the more complex OTC contracts that cannot be standardised and will continue to be traded bilaterally, which brokers will have to pass on to their clients.
These costs could make the OTC market uneconomic for buy-side firms that currently use customised derivatives to offset existing positions, potentially reducing liquidity in more esoteric instruments.
The type of trading venue selected for migration of OTC derivatives by regulators could also pose a problem, particularly in Europe where this activity could fall under the remit of multilateral trading facilities (MTFs).
Products such as inflation swaps or correlation swaps incorporate a number of variables and need the active support of specialist market makers. Without these, liquidity could by restricted on MTFs. This is unlikely to be as much of an issue in the US, where the request-for-quote model mooted for OTC derivatives products migrating to swap execution facilities allows users to specify their requirements to a number of broker-dealers before obtaining multiple prices.
In addition, if the MTF model is chosen for OTC derivatives, there may be a proliferation of new trading venues similar to that seen in the equities space, which could fragment liquidity for OTC contracts in Europe. Both in Europe and in the US, the regulator could theoretically limit the number of OTC venues permitted to support concentrate volumes.
But the biggest question remains: which derivatives will remain OTC? In the US, the Dodd-Frank Act leaves the decision to the regulators, but that doesn't mean the lobbying has stopped. Many market participants expect FX derivatives to remain off-exchange due to the persuasive efforts of large FX dealers, despite the widely held view that the risks associated with trading these types of products is no different to some others covered by the bill.
And if FX derivatives are not included in US OTC reforms, then Europe could well be forced to follow the same route to prevent regulatory arbitrage. The total cost of OTC derivatives reform and how those costs will be apportioned remain far from clear.
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