OTC Markets Diverge Along Jurisdictional Lines

Terry Flanagan

As the world of swap execution facilities, multilateral trading facilities and central clearing takes shape in the OTC derivatives space, some market participants and observers are less than sanguine about the prospects for achieving harmonization across multiple regions and product classes.

“Harmonization would lower the industry cost significantly and make it much more transparent,” said Steve Woodyatt, chief executive of  Object Trading. “I don’t see that happening in a month of Sundays, and the reason for it is that jurisdictions see differences in regulation as differentiation and potentially attractors for business.”

International Swaps and Derivatives Association CEO Scott O’Malia recently spoke about the need for global harmonization of derivatives regulations. “There are different levels of compliance and development of the regulatory structure, data regimes, separate and equal but not working together,” he said at the Isda North America conference earlier this month. “How do we figure out how we can really bring together the service providers and the participants and the SDRs?”

O’Malia suggested as a starting point that regulators agree on common data formats for sharing transaction information. “Many of you are familiar with our experience in FpML, the language that traders use to represent things in the market,” he said. “How can we help regulators improve the quality of their data, so they can more easily aggregate and see into the market across jurisdictions?”

The need for more efficient use of capital and the ability to offset intraday positions will pressure firms to make sure that they have adequate risk management tools and can manage trades routing through different venues.

Isda and other industry groups need to develop documentation, such as the Isda master agreement, that governs both listed and OTC transactions, according to O’Malia.

“Can we, will we, and when will we create documentation for both listed products and unlisted products, so we have a common reference document that everybody can feel comfortable with?” he said. “The buy side can then say, ‘Hey, this is the way we want to trade. On some of these products we want to go listed, some of these products are OTC.’ It works for everybody and they have common, consistent documentation.”

The ability for the buy side to cross margin positions held at different exchanges, also known as fungibility, should be the goal for operators of exchanges and clearinghouses, according to Woodyatt.

In 2012, for example, LCH.Clearnet, New York Portfolio Clearing, Depository Trust & Clearing Corporation (DTCC) and NYSE Euronext agreed in principle to combining NYSE Liffe U.S.-traded interest rate futures contracts cleared by NYPC, fixed income cash and repo trades cleared by DTCC, and interest rate swaps cleared by LCH.Clearnet’s SwapClear service into a single portfolio for purposes of margin netting and offsetting. (NYPC was recently shut down following the acquisition of NYSE by IntercontinentalExchange.)

More recently, LCH has been rumored to be considering cross-margining for its SwapClear and Clearnet clearinghouses.

“There is word out there that LCH as an institution is going to be able to offer soon the ability to offset positions across both listed and OTC markets,” said Woodyatt. “That would allow people to cover their net position, rather than having to lodge double the capital, would stimulate the use of derivatives in risk management, and would save a lot of collateral cost.”

The horizontal model adopted by LCH is in contrast to the longstanding vertical industry model, whereby a particular clearinghouse clears for a particular exchange or set of products, Woodyatt said.

“LCH have had a long stated commitment to a horizontal model where they want to be able to clear for multiple venues and asset classes and be able to cross margin,” he said. “That is the way the industry needs to go as a whole, to be more transparent and to reduce costs.”

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