The rising cost of tailoring

Bespoke instruments that perfectly fit investors’ needs are likely to cost considerably more in future. As market participants cut their cloth according to their means, some may feel more exposed than others.

Will the standardisation of OTC derivatives reduce the opportunities for institutional investors to find contracts that can meet their specific needs? 

Almost inevitably, buy-side firms will lose a degree of control over how they manage risk if it becomes harder to find a customised OTC contract that will cover the exact exposure a firm wishes to hedge.

The potential risks to market stability stemming from the lack of standardisation of OTC contracts are a key concern for regulators in both Europe and the US. As such, the European market infrastructure regulation and the Dodd-Frank Act respectively seek to determine which contracts are suitable for trading on exchange-like platforms and centralised risk management via clearing houses.

Under the new rules, bespoke instruments used by the buy-side to hedge certain exposures that are not suitable for standardisation will be subject to increased capital charges, meaning their continued use will require careful consideration.

If hedging becomes less exact, could the new rules actually increase risk levels for some investors? 

By transferring OTC instruments onto centrally-cleared platforms, counterparty risk is supposedly reduced, so the net level of risk for all market participants decreases. That said, market participants argue the ability of firms to reduce their own risk will be impaired if instruments that remain OTC become more expensive.

Ultimately, the new rules seek to protect the market against the kind of chaos that descended on the OTC market in the aftermath of Lehman Brothers’ collapse, but it is still up to individual firms to ensure their own risk level does not get out of hand.

How much more will the buy-side have to pay to use the more exotic OTC instruments than for those swaps that migrate to exchange-like venues? 

It’s too soon to tell, but last week the European Parliament voted through its version of the Basel III capital and liquidity requirements. The European Parliament’s Economic and Monetary Affairs Committee agreed that systemically important banks will be required to hold an additional capital buffer of 3% - which can be increased to 10%, if deemed necessary.

Market participants will be faced with a choice over how much to spend on their own risk. They can either opt to use a standardised OTC instrument, listed future or option that may constitute a less than perfect hedge, or they can obtain a customised bilateral instrument that will cost considerably more.

As swaps move on exchange, how will the resulting fragmentation affect the cost of doing business for investors? 

Fragmentation could become an issue as new organised trading facilities (OTFs) in Europe and swap execution facilities (SEFs) in the US are established. Nobody yet knows how many such facilities there will be – so its difficult to predict just how fragmented the new OTC world will be.

In the US, regulator the Securities and Exchange Commission has said SEFs could take the form of a request-for-quote (RFQ) system – where participants define the contract they require and request a price from a number of participants – or a limit order book system – leading to further uncertainty.

In Europe, a greater number of multilateral trading facilities, organised trading facilities and systematic internalisers is also expected to emerge as the new derivatives rules reach the implementation phase.

However, market participants have argued that most of the liquidity will quickly migrate to a smaller number of successful venues, with the remainder falling by the wayside – just as they did for equities. Naturally, for the more liquid instruments, initially at least, a larger number of new platforms will rush onto the scene than for lower-volume instruments.

Others point out that in today’s OTC markets, we already have a degree of fragmentation, since buy-side firms need to choose between brokers when negotiating their OTC contracts bilaterally. The establishment of a large number of SEFs and OTFs would impact liquidity in the short term, but those who argue that market forces will create an equilibrium insist that the benefits outweigh the short-term costs.

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