March 2009

DERIVATIVES: Bad reputation

Nicholas Pratt looks at how attempts to bridge the high returns of OTC derivatives with the security of exchange-traded instruments may affect fund managers

Over-the-counter (OTC) derivatives join short selling and sub-prime mortgages in the rogues gallery of the financial crisis. Specifically, critics have singled out credit default swaps (CDS). Following the September 2008 collapse of Lehman Brothers, the somewhat shadowy world of the CDS market was suddenly thrust into the glare of the regulatory spotlight and the relatively lax measures in place to ensure their effective clearing and settlement were highlighted. Regulators were alarmed by the volume of outstanding contracts in the CDS market – a figure which now stands at roughly $27 trillion (€21 trillion) after reaching a peak of $64 trillion during the final quarter of 2008.

In contrast, exchange-traded derivatives seem to represent a more stable trading environment with exchanges acting as  central counterparties to ensure pre-trade transparency and reliable clearing.

Brokers have reported a marked reduction in the OTC market since September. “The fundamental demand for OTC derivatives is still fairly strong in terms of hedging certain exposures but the speculating side of the market has gone down on both the buy and sell sides,” says Martin Higgs, senior vice president and European derivatives manager at State Street. “It is probably a temporary lull but it may well be a lull that lasts for a couple of years. Everyone is keeping their head down for now until more direction comes in to the market.”

Bridging gaps
Exchanges, however, are attempting to make their derivatives offerings more attractive to investors who want more transparency and security, but still seek the flexibility and greater returns associated with OTC instruments. For example, NYSE Liffe, the European derivatives arm of NYSE Euronext, has developed Bclear, which it describes as a hybrid service. “We are trying to bridge the gap between vanilla OTC derivatives and the listed environment where you have STP and very little paper or manual processes,” says Ade Cordell, director of OTC Services at NYSE Liffe.

The OTC market is still associated with flexibility and products that can be tailored to suit very specific needs. Consequently new products tend to start off in the OTC world with potentially high margins before migrating to the lower returns of the listed world once they become standardised enough. However, says Cordell, the vast majority of OTC derivatives are of the vanilla type with standard expiries – in short, exactly the same characteristics that exchange-traded derivatives possess.

“What the hybrid services are aiming to do is provide the best of both worlds – added flexibility to the traditional exchange-based contracts specifically in terms of settlement options, expiry dates, contract styles and a degree of privacy surrounding the contract,” says Cordell.

But is the current demand for the security of centrally listed derivatives sustainable? “I think the demand for these hybrid services will be a permanent feature,” says Cordell.

The marketing efforts of the exchanges and their hybrid services will have been helped by the various regulatory initiatives looking to introduce centralised services for the OTC markets. The most pressing initiative concerns the overhaul of the CDS market.

Legislative threat
Typically there is still a lack of broad agreement between different jurisdictions in Europe, and between participants and service providers. This has prompted the EC to threaten the market with legislation.

Damian Shaw-Williams, an analyst at Datamonitor, says: “It appears that political concerns are now over-riding the commercial. Due to the failure of major European dealers to agree on a solution, a centralised European-based CDS clearing system will be legislated for by the European Commission.”

A battle of sorts has already started between the trade associations representing the respective interests of brokers and exchanges. For example, the Wholesale Market Brokers’ Association (WMBA) says that the perception that exchange-traded markets represent a “more robust regulatory model” is misleading.

There is a danger, says the WMBA, that policy decisions are being considered that “may attempt to force OTC products onto exchanges, resulting in a dramatic reduction in liquidity and product flexibility in markets essential for trading and hedging”.
Nine major brokers (Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley and UBS) have now committed to the EU’s plan for a central counterparty clearing for CDSs in Europe, reasoning that they will better influence events by negotiating from inside rather than complaining from outside.

There are currently four providers jostling for the mandate to provide the clearing platform for the new CDS market in Europe. A consortium involving Markit Partners and the Intercontinental Exchange (ICE) is considered to be the most likely option. Another US-based operator, the Chicago Mercantile Exchange, is also in the running. Meanwhile, NYSE Euronext’s derivatives arm Liffe and Germany’s Eurex are the two Europe-based proposals.

In terms of the relative merits of each platform, the ICE project has the advantage that it has the blessing of the major sell-side banks which have historically dominated the CDS market. However, what is good for the sell-side may not be good for the buy-side, particularly in terms of gaining affordable access to the market.

“For fund managers it is important that these initiatives are not just seen as sell-side projects where the investment banks are too dominant,” says State Street’s Higgs. “The service must be available and accessible to fund managers, particularly those that trade infrequently and in small numbers.”

A structure where a wider range of institutions can deal directly with the clearing house is better for the market as a whole and particularly fund managers, says Rohan Douglas, chief executive of Quantifi, a software firm. “The broader the access, the more opportunity there is for a liquid market with more competition, lower spreads, greater efficiency and greater potential for electronic trading.

Furthermore, the requirements need not be too stringent, says Douglas. “It is not impossible to have reasonable criteria for access that a broad range of institutions would qualify for. It may not be accessible to start-up hedge funds but there are plenty of fund managers out there that are financially sound and have deep pockets.”

Of course, if the appetite for CDS instruments remains as low as it is purported to be, then all these initiatives may be in vain. Douglas, however, believes the lack of demand for credit derivatives has been exaggerated and that the CDS market has been unreasonably singled out by regulators. “If the regulators are concerned about systemic risk, then they have to look at the market as a whole and have centralised clearing for all OTC products.”

For example, the interest rate derivatives market is at least ten times bigger than the CDS market in terms of outstanding contracts and Douglas thinks it would be unfortunate if the focus remained solely on CDS and not IR derivatives. “The perception of CDS being a contributor to the current economic crisis has been created by those not involved in the market. These people seem to have forgotten what happened in Orange County. The next time there’s a bump in the road, people will realise it is a bigger problem than the CDS market.”

©2009 funds europe