Costs of OTC Reforms Assessed

Terry Flanagan

The costs of reforms of OTC derivatives, including mandatory central clearing, margin requirements for non-centrally cleared OTC derivatives, and bank capital requirements for derivative-related exposures will be 0.04% of GDP per year from institutions passing on the expense of holding more capital and collateral to the broader economy, according to a report by the Bank for International Settlements.

The report by the Macroeconomic Assessment Group on Derivatives (MAGD), headed by Stephen Cecchetti, economic advisor to the Bank for International Settlements, showed that the reforms would provide net economic benefits of 0.12% of GDP per year by helping to avert another financial meltdown.

The MAGD was set up by the OTC Derivatives Coordination Group (ODCG), comprised of the Chairs of the Basel Committee on Banking Supervision (BCBS), the Committee on the Global Financial System (CGFS), the Committee on Payment and Settlement Systems (CPSS), the Financial Stability Board (FSB) and the International Organization of Securities Commissions (Iosco).

In February 2013, the ODCG commissioned a quantitative assessment of the macroeconomic implications of over-the-counter (OTC) derivatives regulatory reforms to be undertaken by MAGD. Guided by academics and other official sector working groups, and in consultation with private sector OTC derivatives users and infrastructure providers, the Group developed and employed models that provide an estimate of the benefits and costs of the proposed reforms.

This report assesses and compares the economic benefits and costs of the planned OTC derivatives regulatory reforms. The focus throughout is on the consequences for output in the long run, i.e. when the reforms have been fully implemented and their full economic effects realized.

The main beneficial effect is a reduction in forgone output resulting from a lower frequency of financial crises propagated by OTC derivatives exposures, while the main cost is a reduction in economic activity resulting from higher prices of risk transfer and other financial services.

While these reforms have clear benefits, they do entail costs, the report said. Requiring OTC derivatives users to hold more high-quality, low-yielding assets as collateral lowers their income. Similarly, holding more capital means switching from lower-cost debt to higher-cost equity financing. Although these balance sheet changes reduce risk to debt and equity investors, risk-adjusted returns may still fall. As a consequence, institutions may pass on higher costs to the broader economy in the form of increased prices.

“Costs will rise because there will be additional cost for margining,” said Udi Sela, vice president of client solutions at Numerix, in a video blog. “So every time my position exceeds a certain threshold, I’ll be required to post additional collateral. And this would be for more trade types than there were previously. So clearly, this would impact the cost of trading.”

Despite statistical uncertainty and the need to make various modeling assumptions and to employ only the limited data available, the MAGD report concludes that the economic benefits of reforms are likely to exceed their costs, especially in the scenarios with more netting.

Therefore, to maximize the net benefit of the reforms, regulators and market participants must work to make as many OTC derivatives as possible safely centrally clearable, with either a modest number of central counterparties or with central counterparties that interoperate. This should include efforts to harmonize the rules governing cross-border transactions, so that market participants have equal access to CCPs.

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