OTC Markets in Transition

Terry Flanagan

The market for OTC interest rate derivatives is changing rapidly, partly as the result of regulatory changes that aim to make the market more transparent and reduce counterparty risk, according to a report by the Bank for International Settlements. For instance, an increasing share of transactions is being centrally cleared.

But there are also other changes, such as the declining role of the inter-dealer market. The market continues to revolve around a limited number of large dealers, but they trade less among themselves than previously.

“These changes will have implications for market liquidity,” the BIS report said. “Tighter regulation will make trading in this market more costly. But at the same time, it will reduce counterparty risk. How both factors will impact market liquidity remains to be seen.”

The changes will also affect how OTC derivatives markets statistics will be collected. More data will be stored centrally by electronic trading platforms, central counterparties, data warehouses and trade repositories. Several jurisdictions are introducing mandatory trade reporting to regulators.

All this should reduce the cost of providing market-wide information. At the same time, all these potential data sources cover only part of the market.

In the United States, the Commodities and Futures Trading Commission published rules requiring interest rates swaps to be traded electronically on swap execution facilities (SEFs).

“Five years after the financial crisis, the swaps marketplace truly has been transformed. Now, bright lights of transparency are shining on the $380 trillion swaps market,” said CFTC chairman Gary Gensler in a speech last week. “Now, a majority of the swaps market is being centrally cleared – lowering risk and bringing access to anyone wishing to compete.”

The longer-term impact of regulatory reforms on OTC turnover is not clear, the BIS said. Most of them, for instance the requirement that transactions be centrally cleared, affect turnover only indirectly, with effects running in both directions.

For example, lower counterparty risk owing to central clearing and higher collateralization could spur turnover, whereas higher transaction costs owing to tighter collateral requirements could reduce it. Another possible outcome is that some market participants will begin to use exchange-traded contracts – how far this is already the case is unclear. Turnover in government bond futures, which could substitute for swaps, has increased slightly between 2010 and 2013, according to the BIS.

Administrative trades are another factor affecting the way turnover data are collected and interpreted. A large chunk of OTC derivatives transactions are not “price-forming” trades, but administrative transactions used to manage derivatives books. At the moment, neither the BIS Triennial Survey nor other publicly available sources differentiate between price forming and administrative transactions.

Related articles

  1. The first amendments to the CFTC's swap data reporting rules come into effect on December 5.

  2. CEDX is planning to expand its range of products in 2023, subject to regulatory approvals.

  3. The paper proposes a path forward for standard SLD documentation.

  4. Exchange group’s crypto suite has had consistent volume and open interest growth.

  5. The derivatives venue owned by FTX wanted to offer products that were not fully collateralized.