OTC Derivatives Markets Seek New Normal

Terry Flanagan

Capital markets are undergoing massive changes in anticipation of new rules for over-the-counter derivatives, but the end result of these rules is unclear.

The stated goals of the U.S. Dodd-Frank Act, the European Market Infrastructure Regulation in Europe and similar regulatory initiatives is to make the OTC derivatives markets more transparent by requiring that most swaps be traded on a swap execution facility and centrally cleared through a designated clearing organization.

But transparency is a double-edged sword, according to some experts.

In particular, by requiring firms to expose their derivatives activity to the markets at large and to regulators through swap data repositories, the regulations may have the unintended consequence of restricting such activity or pushing it offshore.

“Transparency is not the unmitigated good that people make it out to be,” said Steven Lofchie, partner at law firm Cadwalader Wickersham & Taft. “The notion that anything is an unmitigated good is simplistic. For example, if the market knew that a major buy-side institution had pulled its business from a major sell-side institution because it was worried about its credit, might that ‘transparency’ precipitate a run on the bank? By the same token, sudden jumps in credit default swap spreads being completely transparent may prove a mixed blessing to market stability.”

One of the goals of impending regulations is the introduction of central clearing which allows electronic confirmation and settlement of OTC derivatives.

“Both buy and sell side firms are investing significantly in systems that provide the required connectivity,” said Rohan Douglas, founder and chief executive of Quantifi, a provider of analytics, trading and risk management solutions.

“In this new environment, the emphasis is on efficiency, automation, connectivity and transaction cost. In many firms we are seeing a trend towards specialized, best-of-breed components that provide a more flexible trading infrastructure.”

The transition from a mainly bilaterally cleared OTC business to a centrally cleared OTC derivatives market is likely to be accompanied by an increase in exchange-traded derivatives that are the economic equivalent of OTC transactions.

For example, OneChicago (OCX), a security futures exchange, provides a marketplace for trading over 2,800 futures in more than 1,500 individual equities and exchange-traded funds.

OCX’s Exchange Future for Physical is the economic equivalent of OTC equity swaps, specifically stock lending and equity repo transactions.

Securities lending and equity repos, which are secured lending of stock for cash or the lending of cash for collateral, are covered by a binding ISDA agreement, which provides for the terms of the loan.

Another example is the U.S.-based futures venue Eris Exchange. Eris Exchange, as a designated contract market (DCM), provides forward starting interest rate swap futures that are cleared by clearer CME Clearing and traded on Eris SwapBook and Eris BlockBox.

The Eris Exchange model collapses multiple cash flows associated with OTC swaps into a single futures price and cash flow which transfers through variation margin in a futures clearing account, according to the company.

OTC derivatives volumes have held steady despite the impending changes in clearing and execution.

Interest rate derivatives compose over 80% of all derivatives trading, according to Celent, a research firm. However, other products such as FX and credit derivatives are increasing their share. From a profitability point of view, FX derivatives trading has been almost as profitable as interest rate trading for banks, Celent said.

The wild card is the possibility that companies that engage in derivatives trading for either hedging or speculative purposes will move their business offshore in response to the Volcker Rule, which restricts proprietary trading, or other elements of Dodd-Frank.

“Markets are truly global,” said Douglas of Quantifi. “Regulatory arbitrage will become increasingly likely as regulations become more complex and the challenges of co-ordination and uniformity become larger. The new OTC market regulations highlight this with significant challenges being faced to co-ordinate the different needs and characteristics of the different regions.”

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