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Lawmakers gun for OTC deals

While regulatory reforms can introduce improvements to complex investment products such as standardisation, Dr Arjuna Sittampalam, Research Associate with EDHEC-Risk Institute and Editor, Investment Management Review, argues an increased suppression of complexity could be unfortunate, particularly as pension funds begin to take to derivatives in a big way.

The serious and potentially systemic danger posed by counterparty risk hit the headlines in the past year. Regulators naturally reacted. The fear was that, should one bank default on its counterparty obligations, a chain reaction could set in, as those who dealt with it in turn ran into trouble, and so on.

Regulators began by insisting that over-the-counter (OTC) deals in credit default swaps (CDSs) should be channelled through a third-party institution that would effectively insulate the two sides of the deal from the potential default of the other. Though the case for such central clearing was not clear-cut in all cases, the industry obliged and organisations were set up to follow the authorities’ dictate. Central clearing houses, known as central counter-parties (CCPs), in the US started dealing with CDSs in 2008, and separate organisations sprang up in Europe this (European) summer in response to the European Commission’s insistence on Europe having its own CCP.

The authorities did not stop there, however. In May, the US’s Obama administration revealed widespread proposals to regulate OTC derivatives, and the EU followed suit with similar proposals in July.

The proposed rules

The US reforms outlined four ways to deal with counterparty risk and to improve the security of derivatives’ dealing overall.

1. All standardised derivatives should be centrally cleared.

2. The industry should be encouraged to use regulated exchanges, instead of the clubby investment banks, because investors get equal access to price data with exchanges only.

3. All institutions should record every trade.

4. Capital buffers should be required for all players in derivatives. It is not certain whether the authorities really mean that all users of derivatives should be subject to this rule even when they are carrying out genuine hedging activities where risk is being reduced, for instance, pension funds hedging against market risk, or physical users of commodities. If so, this would be preposterous, imposing a totally unnecessary cost on these players (who are actually reducing risk and posing no threat to anybody else, provided they put up the appropriate collateral at the time) and merely inhibiting their use of derivatives.

The EU proposals published in July generally follow the same approach and the industry has broadly accepted the central thrust, though many problems have been highlighted. The central clearing requirement is already in place to a large extent. In fact, for interest rate derivatives, the largest component of the OTC market, a clearing system has been in force for a few years, with SwapClear, owned by LCH Clearnet, the leader, dealing with $85 trillion, which represents 60 per cent of the transactions of the group of the 22 largest banks. As stated above, credit default swaps (CDSs), the villain of the credit crunch saga that instigated the reforms, are now subject to central clearing.

Intercontinental Exchange (ICE), having already established itself as the clear market leader for CDSs in the US by early this year, was well ahead of its main rival Eurex in Europe by August.

Scope of proposals

The main regulatory reforms are not confined to the US and Europe. SGX, the Singapore Exchange, also has central clearing under consideration. China, though also not having central clearing, has for years required banks to report every deal, an insistence seen as bureaucratic once, but wise now. This is an example of China moving towards top global standards, though as yet its OTC market is tiny, representing only 1.5 per cent of the global total.

A potential turf war is a by-product of the proposed rules. In the US, the Securities & Exchange Commission (SEC) is responsible for securities supervision, while the CFTC looks after commodities. Some OTC deals, however, straddle both areas and who is to be in charge is still to be resolved.

The rules are two-pronged. They cover the institutions dealing in derivatives as well as the instruments themselves, and there is much questioning of the need for the latter, assuming the former is tightly carried out. The CCPs have a membership structure, with only the members being able to deal with them. Hitherto, membership has been restricted to the main investment banks. But the authorities have stipulated that the buyside should be eligible as well, subject to risk assessments, so that the latter can bypass the investment banks and go to the CCP directly, a highly desirable objective for the asset managers. This particular aspect is still being discussed.

A major plank of the proposals lies in the concept of standardisation, given that they stipulate that standardised derivatives only be subject to central clearing or move to exchanges. Since the concept of clearing and exchange dealing requires a large number of identical instruments which are interchangeable, this restriction is natural, but the problem is that many OTC deals are of a bespoke nature, being tailored to meet particular needs and not susceptible to standardisation.

Some contracts can be standardised in the sense that at issue they can follow the same format. This process is now being applied to many European CDSs, reflecting progress in this field. Natasha de Teran, technology correspondent of the Financial News, thinks that the authorities are struggling with the definition of standardisation, and they might have to be for some time to come. If her surmise is correct, then it will be a while before the proposals become actual rules.

Size of market

The overall size of the OTC market is estimated to be $600 trillion, of which the bulk is in interest rate derivatives, while credit derivatives account for less than $50 trillion. However, these large figures are misleading, since many deals counteract each other, and the net exposure of the entire OTC market is estimated by the Bank for International Settlements (BIS) to be only about $34 trillion, much smaller but still a mind-boggling sum.

Nevertheless, the bigger figure of $600 trillion has relevance, as for instance the fees that investment banks charge on deals are based on gross transactions. BIS data suggest that 80 per cent of outstanding derivatives are OTC. The credit crisis has resulted in the first decline in the overall derivatives market since 1998.

Winners and losers

Among the various types of market participants, winners and losers are emerging. Investment banks have hitherto found OTC derivatives deals a huge honeypot, with profits contributing significantly to their bottom line. If these deals are moved to exchanges, or made into more standardised contracts, margins are bound to shrink.

The regulated exchanges, on the other hand, are chortling, as they look forward to more volume shifting from the OTC sector. The situation is more mixed with another class of intermediary, the inter-dealer brokers. These firms have played a pivotal role in bringing parties together in the OTC sector and some of them could clearly suffer as the business shrinks. On the other hand, Icap, one of the largest, is relaxed, at least publicly, as it can boast of electronic dealing systems, which the authorities are encouraging.

Asset managers and institutional investors face mixed fortunes. In many cases, they will save money from the deals migrating to registered exchanges with transparent margins and prices, and from the flexibility of being able to close out a derivatives deal with a party different from the one with which it was opened.

On the other hand, there are situations where they need bespoke deals, to cater for particular needs. For instance, pension funds use interest rate and inflation swaps matched to their own liabilities structure. The fear is that their choice will be limited and their risk management will be hindered, which could have serious implications for their financial well-being. The Pension Protection Fund set up by the UK government had a shortfall of £189billion at the end of April, and this figure would have been £20billion-40billion higher were it not for OTC derivatives positions.

Another important group of players is the corporates who need to deal in derivatives for specific risk management strategies, such as hedging exposure to commodities or interest rates. These, by and large, need to be tailored to their own needs and, as with pension funds, their risk management could be severely hampered. An unintended consequence of the new reforms, undesired by the authorities, is that the risks and the price of their underlying business could be increased. Under the new reforms, furthermore, occasional dealers such as corporates and sovereigns might find the instruments prohibitively expensive. For example, bank fees could rise from 0.1 per cent currently to 2 per cent.

Overlooked problems, old and new

It is suspected that a substantial proportion of OTC derivatives might never be subject to central clearing, as the CCP will not be able to guarantee their safety, for one of several reasons, such as illiquidity or poor pricing, or even users’ inability to afford the charges. There is the danger that, under the pressure of regulations, the CCPs might take on risks they are ill-equipped to handle, bringing their own soundness into question. Natasha de Teran suggests that regulators have a vested interest in promoting central clearing, and pushing deals into the clearing system, while overlooking the risks. In fact, there are presumptions built into the draft rules that suggest this might happen. She thinks that sizeable academic scepticism regarding the project has not been acknowledged and that a $600 trillion industry might come to rest on a system based on scarce experience and unwarranted assumptions about the CCP’s capability to manage the new risks.

Another well-known writer and regular FT columnist, Satyajit Das, suggests that the new rules miss out on the systemic risks, and on several counts. Part of the problem during the credit crisis was mis-selling by the investment banks, to customers who did not understand the products, and negligence on the latter’s part in not making sure they understood. Das also felt that liquidity risk in the market might increase if a large number of participants are subject to margin calls. He highlighted other systemic risk deficiencies as well, such as the impact of CDSs on risk-taking behaviour and the concentration in some markets among a handful of large dealers.


The reforms will introduce some significant improvements, such as more standardisation where possible, but if the result is an increased suppression of complexity then it could be unfortunate. Complexity, like innovation, has a bad name nowadays, because of having been taken too far during the boom, with esoteric instruments such as CDS-squared. However, there is a genuine need for many forms of complex derivatives, as corporates, pension funds and asset managers would attest, and it would be a great pity if these are discouraged by regulation or higher costs.

In recent years, pension funds and investment management houses have begun to take to derivatives in a big way, enabling them to carry out better risk management and to offer wider choice to the beneficiaries. It will be a tragedy if this trend is reversed by hasty, ill-thought-out regulatory pressures.

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