OTC markets alive and well

By Patricia Cullen

7 March 2019

“Banks incorporating blockchain could have an advantage here - Commerzbank have conducted OTC bond trades on the blockchain which improves settlement times and allows for accurate reporting of the trades. That is one aspect of where I see OTC markets moving,” writes David Belle, author of the Macrodesiac Newsletter.

Over the counter (OTC) trading offer companies more flexibility because, unlike the ‘standardised’ exchange-traded products, they can be tailored to fit specific needs, helping organisations provide consumers with stable prices. The size and scope of markets for hedging have grown with the development of sophisticated strategies, with approximately 95% of the world's 500 biggest companies using derivatives.

In response to the crisis of 2008-2009, the G20 agreed to a financial regulatory reform agenda covering the OTC derivatives markets and its participants. Amongst the post-crisis reforms was the obligation to post initial margin (IM) on non-cleared derivative trades, which has been instigated in phases since 2016. Presently, Phase 3 entities have more than $1.5trn in aggregate average estimated amount (AANA) of uncleared derivatives at the group level. These, alongside those set to come in in September 2019 ($750bn AANA threshold for Phase 4) – are all reasonably big entities. In September 2020, Phase 5 will showcase a ‘cliff effect’, when the AANA threshold for compliance drops to just $8bn. This shift will bring into scope more than 1,100 counterparties, akin to approximately 9,500 trading relationship and up to 19,000 new custodial relationships that will need to be established, according to an International Swaps and Derivatives Association (Isda) survey.

The G20 2009 reform agenda also included a commitment for standardised derivatives to move to clearing, and in November 2018 the FSB and other Standard Setting Bodies (SSBs) published its report co-chaired by the Bank of England (BoE), which analysed pricing and qualitative survey data collected from cross-regional industry participants. The report found that the post-crisis reforms, particularly those relating to clearing, capital and margin, appear to create an incentive to centrally clear. The report also noted that non-regulatory factors, such as market liquidity, counterparty credit risk management and netting efficiencies, are significant and can interact with regulatory factors to affect incentives to centrally clear. Recommendations included that the SSBs ensure clearing is appropriately incentivised, examining the treatment of initial margin in the leverage ratio, aspects of the G-SIB methodology, and further investigation of the economics of client clearing and access to clearing services. The rules for uncleared margins are gradually being introduced, with the final date for full compliance set for September 2020, and the amount of uncleared margin posted from Q1 to Q4 last year was up by almost 25%, according to the Isda. Changes are detailed in Isda’s regular SwapsInfo trading statistics, showing that 88% of interest rate derivatives trading volume reported to US swap data repositories was cleared last year. 

A London Stock Exchange Group spokesperson echoes this trend to move the majority of trading into cleared markets stating: “Over recent years, the number of asset classes being centrally cleared has been growing. This is driven in part by regulation, which has provided positive tailwinds for LCH. Most recently, we’ve seen a further rise in cleared volumes in OTC derivatives, such as FX, following the introduction of the uncleared margin rules, which is driving market participants to clear more.” Firms have to hedge FX exposure somehow, otherwise they may face adverse effects on their revenue.

For those products fit to be cleared, it’s a reputable way of mitigating counterparty credit risk, but there has been some deviation in CCP risk management approaches worldwide, including how the Principles for Financial Market Infrastructures has been understood and applied. There are a number of incentives that have driven this move to clearing - risk management netting and capital benefits – and, analysis of data reported to US swap data repositories shows the industry is clearing more than is required under US regulations, according to Isda’s Actual Cleared Volumes vs Mandated Cleared Volumes: Analyzing the US Derivatives Market paper. This comprehensive shift to clearing means it is imperative that CCPs conform to the very highest standards of risk management – and this has become all too evident following the recent member default at Nasdaq Europe.

Sir Jon Cunliffe, Deputy Governor for Financial Stability of the BoE, at the Official Monetary and Financial Institutions Forum, London, February 22, 2017 said: “Given their role, CCPs are by design systemic and need to ensure they handle risk very prudently, particularly the risks from the disorderly failure of their key counterparties – which typically consist of the systemically important global banks. Ensuring that these banks are themselves able to fail safely will reduce the risks to the CCPs of which they are members.”

However, not all derivatives can be cleared - those that are less standardised or liquid are not suitable for clearing. The Incentives to centrally clear over-the-counter (OTC) derivatives report by the FSB, the Basel Committee on Banking Supervision (BCBS), the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (Iosco) recognised that ‘some derivatives, notably those which are non-standard and/or illiquid may not be appropriate for central clearing’.  Since they are customised to specific exposures, the derivatives may not meet the strict requirements for clearing suitability. Besides, it was never the intention of regulators to eliminate the non-cleared market as they recognise there is a place for non-cleared derivatives that offer key risk management benefits.

In January 2016, the BCBS published revised standards for minimum capital requirements for market risk. Value at Risk (VaR) was criticised immediately after the crisis but it still plays a fundamental role in risk management today. The Bank for International Settlements created an Amendment in 1996, making VaR reporting compulsory for bank regulatory compliance.

The market risk framework is expected to come into being in 2022, and once instigated, the new framework is expected to result in a weighted average increase of approximately 22% in total market risk capital requirements relative to the Basel 2.5 framework. (The framework issued in 2016 would have resulted in a weighted average increase of around 40%)

The derivatives market, especially credit default swaps, has been heavily targeted in the aftermath of AIG and Greece, and more recently, the Norwegian trader Einar Aas, who put a €114m hole into Nasdaq's contingency fund for derivatives trading in European energy markets. Members of Nasdaq’s Nordic commodities exchange were forced to replenish the clearing house contingency funds that were lost in the default. They were given a March deadline by Norway’s financial services regulator to introduce new supervisory reforms in the wake of the massive default on its Nordic energy exchange.

The main regulatory reform initiatives in the US, EU, and other developed financial markets are addressing important issues. In some cases the trading is being shifted from OTC markets to exchange markets. In others, the post-trade clearing process of OTC trades is being moved increasingly into clearinghouses, and trade reporting for OTC transactions is also part of reform efforts. The Incentives to centrally clear over-the-counter (OTC) derivatives report concludes that the ‘results from the DAT’s analysis suggests that, overall, the reforms, are achieving their intended goals of promoting central clearing, especially for the most systemic participants.  This is consistent with the goals of reducing complexity and improving transparency and standardisation in the OTC derivatives markets.’

Finally, the joint statement by the BoE including the Prudential Regulation Authority, Financial Conduct Authority (FCA), and the US Commodity Futures Trading Commission (CFTC) states that “market participants can be confident that the clearing and trading of derivatives between the UK and US will maintain the high standards of today when the UK leaves the EU.”

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