Right or wrong, the OTC derivatives markets have been identified as one of the central parts that need reform. The template for that reform, particularly in the US, has been the ETD derivatives market, which performed well all through the economic turmoil.
Dodd-Frank legislation in the US and EMIR and MIFID II regulations in the EU are the means by which the OTC derivatives markets are being transformed. Despite delays, the US rules are expected to be in place at the start of 2012, the EU at the end of that year.
If we use the currency split of the interest rate (IRS) OTC derivatives notional outstandings as published by the BIS as regional indicator, these two jurisdictions between them cover more than 80% of the global OTC derivatives business, estimated at $ 601 trillion outstanding notional amount at the end of 2010 by the BIS.
So how will these rule changes impact the OTC derivatives markets?
Firstly they will mandate that a large part of the transactions will need to be cleared by a central counterparty, similar to what has been the case in ETD markets for years. Citibank in a recent study estimates that 90% of the OTC IRS market (by far the largest of the OTC derivatives markets with $465 trillion outstanding) will be clearable, 85% of the CDS market, 75% of the equity derivatives and commodities market and 55% of the FX derivatives market.
LCH recently announced that they will be able to process 84% of all OTC IRS derivatives for clearing. The estimates by other market experts are in the same ballpark, so a substantial part of the OTC derivatives market will be affected.
CCP Clearing will have a profound impact on the market structure. No longer will counterparty credit quality be a differentiator. Similar to the ETD markets, the playing field will level out over time.
Other rule changes will contribute to this such as increased pre and post trade transparency as a result of MIFID II, non discriminatory access to SEF platforms in the US etc. Punitive capital charges and daily bilateral margining requirements for OTC derivatives not cleared through CCPs will make it difficult to escape CCP trading.
One inevitable consequence of this development will be commoditisation and the margin compression resulting from it.
To compensate processes, front, middle and back office, will need to be streamlined. Is there still a need for separate affirmation platforms or will trades be transferred directly into the clearing house, as is the case for ETDs?
Is there still a need for ISDA agreements or are these superseded by clearing agreements and rulebooks of the CCPs? Currently this is not envisaged, but margin compression and cost pressures will surely focus minds once the new markets begin.
The other consequence will be an increase in trading activity. To compensate for reduced margin, but also as a result better transparency and less perceived risk, OTC volumes are likely to rise. Market participants will have to adjust their business strategy to this new world.
The levelling of the playing field is also likely to result in the entry of new market participants, such as the prop trading firms active in today's exchange traded derivatives markets. Trading frequency will increase and average notional sizes decrease.
Market structure, trading methodology and activity as well as processes in the OTC derivatives markets will over time increasingly resemble the practices in ETD derivative markets. But will ETDs replace OTC derivatives?
I dont believe so. There is still demand for flexible dates as opposed to the fixed dates of typical ETD contracts. Closer integration of both markets will also facilitate arbitrage between them, thus securing volume for both. The OTC markets also tend to be ahead of the curve in creating new products to satisfy specific needs. And central limit order books may not be the right method to trade the more illiquid OTC derivatives.
So will the markets converge towards the ETD model? Definitely, but OTC derivatives will not go the way of the dinosaur and disappear.
Christian Baum is a consultant at Riverdale Associates