Swaps ‘Futurization’ Confronts Markets

Terry Flanagan

Market participants are concerned that centralized clearing for standardized OTC derivatives will likely significantly force up costs in exchange-traded derivatives markets, and it may also see many firms just turn their back on the practice of hedging risk altogether.

With regulators having adopted new rules to monitor the previously opaque $700 trillion OTC derivatives markets, exchanges, in particular, are concerned that the listed derivatives market, which is about a tenth of the size of the OTC derivatives market, faces onerous new capital standards.

The new rules will see most standardized OTC derivatives contracts forced through centralized clearing and eventually on to exchange-like venues to reduce systemic risk. More exotic derivatives products, seen as unsuitable for exchange trading, will remain OTC but will be subject to even higher margin requirements.

“As OTC reform continues to alter the trading strategies of investment banks, the regulators are unwittingly driving a change in where banks conduct their trading,” said Jeremy Taylor, specialist in operational processing and derivatives at Rule Financial. “Imposing the tough rules on the OTC derivatives market, the Dodd-Frank Act in the U.S and Emir/MiFID 2 in Europe, along with other regulators around the world are now forcing all players in the industry to assess their choice of venue for derivatives trades. When their calculation leads them out of the OTC Swaps market and into futures then this is futurization.”

Margin calls were not previously needed for private OTC derivatives contracts, although this subjected them to counterparty risk.

The new regulations aim to add transparency and reduce risk by shedding light on these contracts. Thus, initial margin requirements will be needed to trade all derivatives contracts in this new environment and the G20 regime is likely to spill into the listed derivatives sphere, which is already subjected to margin requirements—albeit somewhat lower—and boasts a more transparent structure.

“By and large, the Dodd-Frank Act has not addressed listed derivatives, but rather OTC derivatives, which were perceived as the catalyst for the financial crisis,” said Sam Priyadarshi, head of fixed income derivatives at Vanguard. “There are, however, some ramifications for the listed derivatives markets, such as the migration of swaps from the OTC to the futures world.”

Futures exchanges have created newer versions of their swap futures contracts that provide for lower margin requirements. “These newer designs have features that are based on lower margin requirements for futures, specifically, a two-day margin requirement versus a five-day requirement for swaps,” Priyadarshi said.

The World Federation of Exchanges has called on international regulatory bodies to modify capital standards to appropriately reflect the liquidity and efficiency of exchange-traded derivative markets.

The WFE has requested global standard setters to eliminate the five-day margin period of risk banking capital standard for exchange-traded derivatives and demonstrate international support for the more appropriate one-to-two day standard for the highly liquid, transparent and efficient exchange-traded derivative markets.

The WFE is concerned that the Basel Committee on Banking Supervision (BCBS), a group of central bank governors from the world’s leading economic nations, wants to introduce stricter initial margin calls—a blanket five-day margin period—than the approach set out by the International Organization of Securities Commissions (Iosco), an umbrella group of global regulators, which advocates a one or two day standard for exchange-traded derivative instruments.

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