March 2010

OTC DERIVATIVES: cleaning job

Nicholas Pratt reviews the regulatory developments in the OTC derivatives world and discovers that it is still unclear just what the cost of these reforms will be to fund managers
cleaner.jpgThe world of over-the-counter (OTC) derivatives continues to move at pace. Each regulatory announcement brings a mixture of measured responses from industry associations. Meanwhile the market participants and their service providers attempt to anticipate any changes in the offing and what it will mean in terms of trading strategies and infrastructure costs. The financial crisis and the part played by OTC derivatives in the whole mess meant that some kind of reform was inevitable, however it is less clear what these reforms should be and who is best placed to make them.

At the beginning of March, the Wall Street Journal reported that the European Commission had sent a questionnaire to various banks, investors and regulators to find out exactly what strategies hedge funds are pursuing with credit default swaps (CDS) so that it could decide whether or not to introduce new rules for this controversial market.

While the EC embarks on a fact-finding mission, the world’s major dealers are doing their best to preempt any possible legislation by promising to clean up the OTC derivatives market.

A collection of major dealers, investor groups and industry associations wrote to global supervisors to commit to greater levels of transparency, improved post-trade processes and greater risk management.

In terms of central clearing for OTC derivatives, the group pledged to broaden the number of instruments eligible for clearing as well as increase the percentage of these instruments that will be cleared centrally – 85% of new and historical credit derivative trades, up from 80%; 75% of historical eligible interest rate trades, up from 60%.

More interestingly for fund managers, the group has also promised to remove many of the operational, legal and risk management barriers to buy-side clearing, as well as considering further standardisation across interest rate and equity derivatives.

“The commitments that the industry is making build upon solid foundations already laid and further underscore our focus on transforming and strengthening the OTC derivatives markets,” says Eraj Shirvani, chairman of the International Swaps and Derivatives Association (Isda) and head of fixed income at Credit Suisse. “They reflect the strong partnership of the major dealers, significant buy-side institutions and global supervisors with a goal of reducing systemic risk by improving market transparency, standardisation and risk management practices.”

As well as listing the new goals in central clearing, transparency, standardisation and bilateral collateral arrangements, the letter also lists a number of achievements already made by the industry, such as:
  • the implementation of a revised and formal Isda governance framework with increased participation of the buy-side in the strategic agenda, policy formation and decision-making progress;
  • significant progress on product standardisation for credit derivatives;
  • significant progress in the implementation of data repositories with the achievement of universal data repository coverage for credit derivative products and the launch of the Interest Rate Derivative Data Repository;
  • delivery of proposals for improvements to the OTC collateral process;
  • continued improvement in industry infrastructure, as measured by further reduction, and in some cases, elimination, of unsigned transaction confirmation backlogs, and continued improvement in operating performance metrics;
  • the successful launch of CDS clearing in Europe, the recent launch of single-name clearing in Europe and North America, and the extension of clearing services for the buy-side.
“Significant progress has been made and continues to be made as the industry works proactively and cooperatively with regulators and policy makers globally,” said Stephen O’Connor, chair of Isda’s Industry Governance Committee and managing director at Morgan Stanley. “While work remains to be done, actions taken to date have fundamentally changed the OTC derivatives markets for the better. Many of the measures, and central clearing in particular, serve to significantly reduce systemic risk.”

While this apparent level of cooperation between the EU and the US will be encouraging for buy-side market participants, there are inevitably a number of consultation papers, draft reports and outline proposals all addressing the same issue but from different bodies in both the US and Europe that, at some point, will need to be brought together.

In January, the Committee of European Securities Regulators (Cesr) published a consultation on guidance for investment managers to report any OTC derivatives transactions. According to Cesr, the purpose of the consultation is to define useful common standards for each derivative type, how the transaction reports should be structured and filled out and to clarify exactly what derivative types will be reportable. The consultation period ends on April 1.

Vision for reform
Meanwhile Werner Langen, a German MEP and member of the European Parliament Economic and Monetary Affairs Committee, has published a draft report outlining his vision for the reform of the OTC derivatives market. In summary, the report supports the general calls for increased transparency, greater risk management and mandatory clearing of standardised derivatives through independent clearing houses. Langen also stresses the need for uniform and international regulation as regards the derivatives market, questioning the need for any separate EU legislation in this area, which adds further encouragement to fund managers wanting to avoid any inconsistency between regional regulators.

The vast majority of the derivatives industry resides in North America and Europe, hence the bulk of the reform efforts have been focused in these two markets, but we are now seeing the first signs of new regulations in the Asian market, which accounts for $600,000bn (€441,019bn) worth of the international derivatives market.

India, China, Hong Kong, Singapore, Korea, Taiwan and Japan have all established task forces in order to look into the feasibility of creating independent clearing houses dedicated to the OTC derivatives market. Essentially these countries are all aware that the derivatives market is about to undergo significant changes with the introduction of central clearing and unless they too introduce similar reforms and establish equivalent infrastructure, Asia could find itself missing out on the next wave of derivatives activity.

But while it is encouraging that Asia is addressing these issues, the concern is that each region will look to establish its own domestic clearing house rather than establishing a pan-Asian framework. The idea of a proliferation of central counterparties (CCPs), all with their own national interests, is one that is likely to increase costs dramatically for any fund manager operating in the Asian OTC markets.

Increased cost is the concern that comes with any new regulatory development and the standardisation of the OTC derivatives market is no different. In recent months, Funds Europe has heard fund managers express concern about the cost of paying for membership for and establishing physical links to all of the new CCPs that are likely to emerge over the next two years. Added to these expenses is the 201 of transparency in terms of reporting all OTC transactions to a central repository.

And there is also the potential loss of flexibility that genuine OTC derivatives give to investors in terms of hedging. As with short selling, there is still some legitimate benefit to these instruments for traditional asset managers, corporate investors and pension funds. They are not simply the playthings of reckless, short-term speculators.

Possible exemptions
So it is inevitable that there is now talk of introducing exemptions for certain institutions involved in the OTC derivatives markets – those that are using these instruments principally for hedging purposes but do not have the financial resources to pay for new infrastructure or CCP membership. In the US, Republican and Democrat senators are clashing over just how wide or narrow the exemption band should stretch and there is plenty of reason to assume that a similar debate will take place within Europe, both at national and EU levels.

As ever, the regulatory machine will continue to produce an intimidating amount of reports, consultations, proposals and drafts, all aimed at providing more clarity and uniformity but actually producing the very opposite. So rather than depending on the regulators to decide their strategy, it seems likely that fund managers would be best advised to decide just how much they are willing to pay in terms of operating, technology and legal expenses to continue using these instruments.

©2010 funds europe

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