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The Future of OTC Markets - ISDA/PRMIA talk


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Presentation given on 1st March at a joint PRMIA/ISDA event in London on 1st March 2012 on the "The Future of OTC Markets"

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The Future of OTC Markets - ISDA/PRMIA talk

  1. 1. The Future of OTC Derivative Markets A brighter/bleaker future for risk managersJohn Wilson
  2. 2. John Wilson• Former Global Head of OTC Clearing & MD at RBS• Led the formation of the OTC clearing business and subsequent development of the clearing solution for House and Client Services• Prominent role in the development of end user services at many international CCPs• Led sales efforts with international client base and provided advice to many key accounts on the impact of clearing and related regulatory changes• Close involvement in the global regulatory debate and frequently represented the industry in Governmental meetings on regulatory change• See
  3. 3. ContentsDrivers for OTC market evolution The Future of Trading and Clearing CCPs: Financial Nuclear Power Stations Collateral WarsCross border tensions
  4. 4. Drivers for OTC market evolution
  5. 5. Financial Crisis• Financial Crisis in 2008/9 highlighted structural weaknesses including – Absence of regulatory transparency on positions or activity in OTC markets – Lack of collateralisation in some notable instances – Inter-connectedness of financial institutions• Policy makers have also claimed – Dealers were making unreasonable profits from opaque markets OTC – OTC derivative prices and capital charges did not fairly reflect their social cost – “Casino banking” is a material threat to retail banking arms – Markets were distorted by the proprietary trading arms of banks – Actions of financial speculators caused harm to the real economy – Counterparty risks present systemic risks to the financial system
  6. 6. Regulatory landscape• G20 Group Meeting in Pittsburgh in Sep 2009 “All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements”• Regulatory framework agenda to meet these objectives – US Dodd–Frank Wall Street Reform and Consumer Protection Act [“DFA”] – EU European Market Infrastructure Regulation [“EMIR”] & MIFID2 – Basel III [EU implementation - CRD IV] – Japan has enacted legislation requiring clearing by end 2012 – Singapore to mandate clearing but not “Exchange” trading – Other regions/countries developing their regulatory proposals including Hong Kong, Australia & Canada
  7. 7. Bank Regulatory Pipeline Overview Not exhaustive, just exhausting! Equity Market Infrastructure Securities Directive OTC Derivatives – Trading Platforms Interest Rate Risk – OTC – Infrastructure Banking Book Non Equities Price Transparency Short Selling Fundamental review of trading book Market Abuse Securitisations OTC – Capital US Banking Market Risk External Credit Ratings Reform Leverage Large FSA liquidity Exposures framework Structural Capital Remuneration Separation UK Bank levy Resolution Systemic Banks Cross-border funding IGL restrictions restrictions Recovery EU Bank Levy Supervisory Basel Liquidity Architecture EU Crisis Management Procyclicality Regulations in final stage Regulations in early stages of policy setting – Actual of policy setting – Impact impact and mitigation and mitigation, Initial steps numbers, appropriateRegulations in early stages of discussion or in external engagement external engagementnot yet identified – Regulatory Intelligence
  8. 8. “The Bigger Picture” for buysideSource: Tony Kirby, E&Y
  9. 9. Capital requirements• Policy makers are determined to increase the cost of using OTC derivatives• RWA levels incentivise cleared over bilateral exposures, notwithstanding some products cannot be cleared• Capital costs for clearing members will increasingly prompt re-evaluation of business case and cause a polarisation of the clearing market – Default fund – Market risk charge on accounts failing to pay margin same day – Capital linked to initial margin• New capital charges reduce bank capacity and widen spreads, but encourage new entrants unfettered by capital charges• Banks will be motivated to unwind existing stocks as part of deleveraging efforts
  10. 10. Trading & Clearing obligations• Mandatory clearing will apply to – Trades between financial institutions, • EU has granted exemption to Pension Funds trading with EU counterparties for up to 6 years and to intra-group trades within EU – Corporate groups in EU which exceed usage thresholds – Third country sovereigns• Key factors in an instrument being capable of being cleared – Standardisation [product, legal, process] – Liquidity – Risk management/modelling• A mandatory clearing obligation will normally create a mandatory trading obligation, with the exception of block trades in the US
  11. 11. Instrument scope for clearing• Regulations have yet to prescribe specific instruments• Clearing exemption in the US for FX Swaps and FX Forward, EU position yet to be determined• Expect the following instruments to be cleared – Plain vanilla IRS, Inflation swaps, Cross Currency Swaps, Swaptions – Index CDS [index tranche less likely] – Some single name CDS [high-grade, rather than high yield] – FX Options* [CCP must guarantee settlement of gross amounts to all parties] – Non-deliverable FX forwards – OTC Equity options – Commodities
  12. 12. The Future of Trading and Clearing
  13. 13. Trade universe The relative dimensions of the quadrants will vary by asset class and product, as well as by turnover v tickets Product can’t be Party exercises SEF & Bilateral & cleared; or No exemption from Not Cleared Not cleared requirement to clear; clearing but chooses or Party exercises their to use SEF exemption from SEF & Cleared clearing and SEF Product obliged to clear Bilateral & but either no SEF or not mandatory cleared mandatory to use a SEFProduct requirement to e.g. block tradeclear & use SEF; or Bilateral & Product can be clearedParty disregards their voluntarily cleared but not mandatory toexemption from clearing use clearing or a SEF; orto both use SEF and clear Party voluntarily clears but trades bilaterally
  14. 14. The OTC Execution Venue Platform routes RFQs /Client A Platform routes RFQs/ Orders Orders / Streamed prices Dealer X Client A Exchange Dealer X Client A Dealer X Client A Platform Dealer X Party Client A Party B A Post trade process varies by SEF model Party A Gives Up to Clearing B self Clearer clears ABC House
  15. 15. Trading• Few products will be suitable for clearing and hence exchange-trading• Clearing is a credit leveller – all counterparties face the CCP and not each other shortly after execution and enable pre & post trade anonymity• Pre & post trade transparency like equity & futures markets, but expected to impact liquidity and discourage firms from making markets in size• Growth in traded notional and transaction volumes, with electronic trading also widening market participation• Fragmentation of liquidity across myriad of venues and across CCPs, with multiple market models operating in parallel including voice• Regional trading & clearing arrangements due to regulatory barriers• Capital costs of bilateral trades drives down volumes for non-cleared trades
  16. 16. Trading• Significant organisational change for dealers – Clearing function required to be independent of “Sales & Trading” – OTC market will move to an agency sales model for “exchange” traded products, most probably commission based – Market making by dealers likely to diminish as spreads tighten, profitability weakens, inventory risk increases and capital burden grows – Rules that inhibit proprietary activity e.g. Volker, will preclude market-making activities in certain entities/products, will entail closing or transferring functions – Increasing spend on technology arms race as for other products, with some re- use of technologies
  17. 17. Prospective SEFsThe new regulations have created new commercial opportunities that many firms areseeking to exploit. This “big bang” is likely to be followed by a “big crash” with firmsexiting or consolidation occurring, reflective of liquidity in asset classes concentratingaround a few “winners” that capture most of the liquidity. A similar pattern occurred inother asset classes such as equities and futures.• BGC Partners, Inc. • MarketAxess• Bloomberg, LP • NASDAQ OMX• CME Group • Nodal Exchange• Creditex • NYSE Euronext• Ederiv • ODEX• Eris Exchange • Parity Energy, Inc.• FXall, Inc. • Tradeweb• GFI Group, Inc. • Tradition North America, Inc.• ICAP • Trumarx• Intercontinental Exchange • Tullett Prebon• Javelin Capital Markets, LLC • Thomson Reuters• LSE
  18. 18. Opportunity for “Smart aggregators”• Pre “Big crash”, fragmentation creates opportunities for firms to provide consolidated/aggregated views across markets, accompanied by smart routing of orders to the “best destination for a given order.• Smart aggregators/routers already exist in equities, futures and FX and typically provide – Holistic views over venues to provide depth and price data on a consistent basis – Routing facilities that provide connectivity to multiple venues on a • Simple basis with the user determining the venue • Smart basis with the router determining the venue • Algorithmic basis, with the router determining how to slice and distribute orders across venues to achieve a balance of speed, best price, minimal market impact – Some venues will not provide users will direct access but insist that there access is “sponsored” by a venue participant/member, and may require orders to be routed via the sponsor rather than submitted directly• Smart aggregator tools will proliferate but may struggle to cope with some market models e.g. RFQ v CLOB
  19. 19. Clearing• There will initially be many CCPs competing around the globe, but regulations will hamper global CCPs• Few CCPs will achieve critical mass, prompting consolidation but progress will be slow and inter-operability will take many years to come to fruition• CCPs will compete on – Cost – Lowest initial margins, offset by larger default funds – Widest range of eligible collateral and liquidity facilities – Segregation facilities – Cross product offsets for margin purposes e.g. listed v otc• Huge tension with members over default funds, due to likely capital costs• Convergence of CCP risk models through regulation and member pressure• Onboarding the industry represents a massive challenge
  20. 20. The end user dilemmaClients using derivatives will face a choice:- • Hedge effectively, and accept the higher cost it will entail; or • Buy a standardised derivative hedge that is cheaper, but remain exposed to basis risk (and loss of hedge accounting treatment) • Opt not to hedge via derivatives End Users: The OptionsChoose bespoke OTC-traded Choose standardised Choose not to hedge throughDerivative Derivative Derivatives• Increased costs through • Basis risk assumed by client • Non-business risks assumed additional capital passed on through difference between by client (earnings to client either via OTC price actual risk and standardised volatility/mandate issues) and margin/collateral. product • Management of market risks• Cost of hedge vs. exchange • May have accounting moved from bank to client traded derivative higher. implications • Cheapest upfront costs for• Non-business risk passed to • Management of market risks clients bank where it can be better moved from bank to client managed. • Cost of hedge to client is lower vs. OTC derivative
  21. 21. Counterparty exposuresCategory Default treatment Collateral treatment New rules on netting sets(A) - Offset with (C) Would not need to be are likely to exacerbateHistoric collateralised for initialtrades margin, only mark-to- counterparty exposures market on the basis of existing Credit Support Annex terms. Netting of variation margin requirement with (A)(B) - Remain as a separate Would attract initial marginCleared netting set per CCP and requirement from the CCPtrades per product, with the and have a cash variation portfolio and related asset margin requirement, purely either being transferred to on cleared trades, with a new clearing firm or separate netting sets per being liquidated CCP and product(C) – Offset with (A) Would attract initial marginNew non- requirement. Netting ofcleared variation margintrades requirement with (A)
  22. 22. Transaction reporting• Onset of new data requirements to support – Legal entity identifiers [“LEI”] – Product identifiers [“UPI”] – Transaction identifiers [“USI”]• Onerous reporting responsibilities to satisfy aggregate requirements from many jurisdictions, which are not necessarily consistent in scope or content or format• Multitude of competing trade data repositories with a regional bias likely and with duplicated reporting to be a common occurrence• Complex reconciliation processes will be required to ensure consistency between own records and regulatory repositories• Eventual migration from transaction reporting to position reporting to risk reporting but the latter of which struggles with cross-asset offsets
  23. 23. CCPs: Financial Nuclear Power Stations
  24. 24. CCPs – The Financial “Nuclear Power” Station
  25. 25. CCP Default - Too big to Fail?• Paul Tucker, deputy governor of the Bank of England and Head of FSB group on CCPs, said the issue needed attention because clearing houses had become centres of systemic risk in their own right, with potentially huge consequences in the event of failure.• Speaking at a European Commission conference in Belgium recently, he said: "There is a big gap in the regimes for central counterparties (CCPs).” "What happens if they go bust? I can tell you the simple answer: mayhem. As bad as, conceivably worse than, the failure of large and complex banks." 25
  26. 26. Counterparty Risk Defaulting Party Impacted Party Execution Client Members CCP ClientsDefault Non-defaulting members A CCP Member Clients of defaulting member Clearing Client
  27. 27. Default of the CCP• There have been examples of CCP failure - HK Futures Exchange 1987, Caisse de Liquidation 1974, the Kuala Lumpur Commodities CCP 1983• Main causes of a CCP failure – Default of members that exhausts its’ “capital” – Lack of liquidity to settle VM following a default – Investment losses• Ramifications – Crystalisation of systemic risk and crash of market confidence – All members and clients affected, positions immobilised – Collateral may be subject to loss depending upon segregation arrangements – Potential losses as unsecured creditors – Inability to use cleared products if alternate CCPs unavailable – Potential liabilities to clients if offering clearing• Mitigating measures? – Reduce positions – Segregation, but its’ effectiveness is questionable – Careful selection of CCPs balance against where liquidity resides
  28. 28. Collateral Wars
  29. 29. Collateral “wars”• Clearing will absorb significant high grade collateral ≈ $2.5tn• CCPs will compete on eligible collateral scope, but perversely the “loosest” CCP will receive “rubbish” akin to ECB operation• Higher collateral requirements on non-cleared trades than cleared trades – US is seeking to impose initial margin for all firms within a US group – EU moving away from initial margin requirements• Governments will seek to influence collateral policy• More firms will be obliged to participate/borrow in repo and stock lending markets to meet their collateral needs• Liquidity requirements will also mean banks have to hoard liquid assets• Increased demands for collateral may create a squeeze on certain assets• Firms will need to devote considerable effort to optimising their collateral use with recognition of collateral as a tradable “asset class”• Custodians will benefit greatly from increased demand for collateral and new requirements to provide independent segregation
  30. 30. Cross border tensions
  31. 31. Cross Border• The Financial Crisis highlighted the interconnectedness of the global financial system• Some emerging regulations appear designed either to insulate countries from “overseas” firms; promote national firms; or retaliate against proposals by other countries – Use of FCMs mandated by US regulations – DFA does not allow for the recognition of a non-US based Trade Repository, hence it is foreseen that US registered firms will at a minimum report to a USA Trade Repository – S716 DFA imposes harsher conditions on US branches of non-US firms than on US firms• Extra-territorial provisions – US regulations on registration as a Swap Dealer apply to non-US firms – Collateral requirements for overseas subsidiaries of US groups• System of international mutual recognition not established• Regional disparities on timing and scope of new rules• More complex corporate structures emerge to fit within regional rules
  32. 32. Timing, Scope & Policy differencesDodd Frank EMIR• [Wider] Scope include • Focussed upon – Execution requirements – Clearing – Clearing and CCPs – CCPs – Push Out – Transaction Reporting – Volker Rule – Trade Repositories – Trade and transaction reporting • Implementation expected early 2013 – Trade Repositories – Reorganisation of regulatory regime and • Exempt pension funds and intra-group creation of oversight council activity – Consumer protection reforms – Tools for financial crises, including a "resolution regime" MIFID2 / MIFIR – Improved accounting and tightened • Focussed upon regulation of credit rating agencies – Position Limits and Large Trader – Trading OTC on execution venues reporting – Pre & post trade transparency• Clearing implementation expected to • Implementation expected mid start Q4 2012 with phased roll-out 2013/early 2014
  33. 33. Cross Border “SEFs”• Based on current tensions, mutual recognition of “foreign” platforms looking challenging• Likely that Execution Venues will need approval in each jurisdiction EU approved US approved to access users in those countries platform platform• Hence if a firm sought to operate in 3 regions on a basis that was accessible to clients from all region, 9 approvals/exemptions may be required• Regulatory linkage between trading Other Nations and clearing facilities may further approved create regional silos e.g. EU trading platforms venue only permitted to access EU approved CCPs [“EMIR Council draft”]; SEFs may only clear at DCO
  34. 34. Global CCPs• Based on current tensions, mutual recognition of “foreign” CCPs looking similarly challenging• Likely that CCPs will be need approval in each jurisdiction to EU approved US approved access users in those countries e.g. CCP CCP UK CCP will need to be authorised by CFTC as a DCO• Regulatory linkage between trading and clearing facilities may further create regional silos e.g. EU trading venue only permitted to access EU approved CCPs [“EMIR Council Other Nations draft”] CCP• Some countries are enacting provisions that will demand that their firms locally clear products in the home currency e.g. Japan and Canada
  35. 35. Summary
  36. 36. Summary• Costs of using OTC products will increase, deterring use• Most active OTC products will be mandated for clearing and trading, with heightened transparency impacting on liquidity• Major shift to electronic trading and adoption of trading tools from other asset classes• Significant increase in operational risk due to complexity of requirements• Clearing will be a credit leveller but entails outsourcing risk management• Counterparty risk may increase due to break-up of netting sets• CCPs enshrined as “too big to fail” entities• Intensive focus on collateral efficiency• Cross border activity impeded with increased regionally focussed activity as a consequence of regulatory barriers• Considerable structural changes –agency business; dealer groups; new liquidity providers;
  37. 37. Questions
  38. 38. John @cdsclearing @irsclearing @otcclearing@fxclearing @clientclearing @otcderivatives