We examine how recent regulatory changes (in central clearing, margin requirements, etc.) are impacting the OTC derivatives market, and causing several leading players to exit. With the spike in clearance and trading costs, a multitude of ratios show how firms are likely to adjust.

1. Cost of Trading and Clearing OTC
Derivatives in the Wake of Margining
and Other New Regulations
Recent regulations are affecting the OTC derivatives
markets in complex, interrelated manners that change the way
firms do business.
Executive Summary
Over-the-counter (OTC) derivatives markets
continue to be impacted by regulatory changes.
These changes are affecting the way financial
institutions do business in multiple, interrelated
ways. Rising capital requirements are impacting
profitability and return on equity. Market partici-
pants are now being forced to clear standard OTC
trades through central counterparties (CCPs)
1
and will soon face margin requirements for the
remaining, nonstandard, uncleared derivatives
(MRUDs). This is prompting firms to better assess
and manage costs (funding, collateral, capital) in
a consistent fashion at a trade, desk and business
unit level. The question is how much of these
costs can be passed on to clients.
These changes are not just impacting sell-side
firms. Central clearing and MRUDs are also
impacting buy-side firms on several dimensions:
funding, risk management and, naturally,
valuation and operations. This paper aims to
better understand:
• The various current and future regulatory ini-
tiatives – transactional and prudential.
• The actual margin valuation adjustment (MVA)
and its mathematical determination through
initial and variation margin adjustments, with
numerical examples enriched with capital,
liquidity and leverage impacts.
• The resulting market evolution from the
standpoint of pricing and volumes as well as
the potential outcomes for market participants.
Regulatory Landscape
Following the 2008 financial crisis, the banking
sector witnessed a plethora of regulatory
changes. While these regulatory prescriptions
cover every dimension of the banking world,
the OTC derivatives (OTCDs) market has borne
the brunt due to the derivatives’ opaque and
complex nature. While some regulations such as
the Dodd-Frank Act,
2
EMIR
3
and BCBS/IOSCO
4
MRUD are directly targeted at OTCDs, several
others, especially the leverage ratio, also have
far-reaching implications for the OTCD market.
Figure 1 (next page) presents a timeline of major
regulations impacting the OTCD market.
All these changes are leading to structural altera-
tions in the OTCD markets, consequently placing
white paper | february 2016
• White Paper

2. white paper 2
significant cost pressure on OTCD trading and
clearing activities. This section provides an
overview of the various recent regulatory devel-
opments that dictate the cost and profitability of
OTCDs (see Figure 2).
Regulatory Timeline for OTCD players
Figure 1
2011 2012 2013 2015 2016 2017 2018 2019
Final framework
published
Timelines extended
Margin (IM/VM) Requirements for Non-Centrally-Cleared OTCDs: BCBS/IOSCO
Final framework applies from 1st Jan 2017
Final
framework
published
Capital Requirements for Bank Exposures to CCPs – BCBS / IOSCO and SA-CCR
Final LCR
rules issued
Basel III liquidity requirements – LCR & NSFR
Phase-in for LCR starts from 1st Jan 2015 till 1st Jan 2019. NSFR from 1st Jan 2018.
Final NSFR
rules issued
Basel III Leverage Ratio and U.S. SLR /eSLR
Basel leverage
rules issued SLR/eSLR to be complied from 1st Jan 2015
Final SLR/eSLR
rules issued
Public disclosure
of Basel leverage
Mandatory central clearing of standardized OTCDs
U.S. (Dodd Frank) – Cat 1: 11th Mar 2013, Cat 2: 10th Jun 2013 and Cat 3: 9th Sep 2013. EU (ESMA) – Cat 1 starts from Q3 2015.
Basel III (CVA) ImplementationRevised Basel III (CVA)
rules issued
Phase-in starts from 1st Sep 2016 till 1st Sep 2020
2014
Risk Components of Cost of Trading OTCDs
Figure 2
High impact
EMIR (EU) & Dodd-Frank
Act (US)
central clearing obligation
BCBS / IOSCO
margin requirements
Uncleared Trades
(MARGINED )
Uncleared Trades
(UNMARGINED)
Cleared Trades
Initial Margin (IM)
• Daily, Unilateral
• CCP Collateral Eligibility
• N/A • Daily, Bilateral, Segregated
• Supervisory Collat. Eligibility
No or low impact Medium impact Very high impact
EMIR (EU) & Dodd-Frank
Act (US)
central clearing obligation
BCBS / IOSCO
margin requirements
Variation Margin (VM)
• Daily, Unilateral
• Mostly Cash
• Weekly (Market Practice) • Daily, Bilateral
• Supervisory Collat. Eligibility
BCBS (incl. Basel III)
BCBS leverage ratio
(Basel III) and U.S.
SLR/eSLR
bank exposures to
CCPs & ctptys
BCBS (Basel III)
CVA Capital Framework
Capital (Risk-Based)
• 2% Risk Weighted Assets
• No CVA
• Basel III RWA
• CVA Capital Charge
• Basel III RWA
• Reduced CVA
• 3% SLR + 2% (eSLR) • 3% SLR + 2% (eSLR) • 3% SLR + 2% (eSLR)
Capital (Leverage)
BCBS (Basel III)
global liquidity standards
• LCR & NSFR
• High Quality Liquid Assets
• LCR & NSFR
• High Quality Liquid Assets
• LCR & NSFR
• High Quality Liquid Assets
Liquidity
‘Close-out risk’
Covers the potential future
exposure to the counterparty that
builds up post default till close out.
‘Position risk’
Covers the current exposure to the
counterparty based on the
mark-to-market P&L.
‘Bankruptcy risk’
Basel III standards strengthened
the global capital framework by
enhancing the risk coverage
Model risk’
Basel III (non-risk based) leverage
ratio supplements the risk-based
capital ratio
‘Solvency risk’
Two metrics for funding liquidity –
LCR (short term, 30-day)
and NSFR (longer term, 1 year)

3. white paper
With an objective to incentivize
central clearing and make the
residual non-cleared OTCD markets
more resilient, global regulators
have issued margin requirements for
uncleared derivatives (MRUDs).
Mandatory Central Clearing of
Standardized OTCDs
The EMIR in the EU region and the Dodd-Frank Act
for the U.S. are the major regulations covering the
central clearing obligation. The implementation
of mandatory central clearing for standardized
OTCDs requires market participants to adhere to
the CCPs’ stringent requirements including initial
and variation margins (IMs and VMs). Margins, in
particular IMs, which are not prevalent in bilateral
deals,leadtosignificantfundingcostforcollateral.
Other costs such as contributions to the default
and guarantee funds of CCPs also add to the
cost burden. From a broker-dealer’s self-clearing
portfolio perspective, there are certain benefits
accrued in terms of obviation of credit valuation
adjustment (CVA) and multilateral netting.
Margin Requirements for Non-Centrally-
Cleared OTCDs
Even after the full implementation of clearing
mandates, there would be a portion of OTCDs
that remain non-clearable (non-standardized or
standard but transacted by parties not covered
by regulation or in currencies that cannot be
cleared). With an objective to incentivize central
clearing and make the residual non-cleared OTCD
markets more resilient, global regulators have
issued margin requirements for uncleared deriva-
tives (MRUDs). Starting September 2016,
5
for
non-centrally-cleared OTCD transactions, large
banks will be required to exchange daily IMs and
VMs with counterparties. The IM requirements
are particularly onerous since it is stipulated to
be a gross two-way exchange with segregation
requirements. The collateral eligibility conditions
(for both IMs and VMs) are quite stringent and
will strain firms’ liquidity. From a cost perspective,
the margin requirements reduce the CVA capital
charge associated with the trades but increase
funding cost, represented by the margin valuation
adjustment (MVA).
Prudential Regulations
Bank Exposures to CCPs
The final policy framework for the treatment of
exposures to CCPs was released in April 2014
6
by
BCBS in consultation with CPMI
7
and IOSCO, and
will come into force from January 2017. Notably,
a new 2% risk weight is applicable to the eligible
clearing members for exposures to qualifying
CCPs; BASEL III capital standards apply for the
transactions facing clients.
8
The most prominent
regulationaddressingCCPresiliencewasadopted
by CPMI and IOSCO in April 2012 in the form of
Principles for Financial Market Infrastructures
(PFMIs),
9
the ‘level 3’ assessment of the imple-
mentation of which started in July 2015.
10
The
“skin in the game” requirements (for example,
in the EU CCPs are required to contribute 25%
of regulatory capital to the default waterfall)
and other aspects of these regulations place sig-
nificant cost pressure on CCPs which will trickle
down to the clearing members and ultimately to
the clients and end users.
Basel III Standards
Basel III reforms are a comprehensive set of
regulatory measures from BCBS to improve banks’
resilience and strengthen their risk management
and governance. They affect different aspects
of banks’ balance sheet management – capital,
liquidity and leverage.
• The risk coverage of capital standards was
enhanced in the relation to counterparty credit
risk – stressed inputs, CVA, wrong way risk
(WWR), etc. CVA requirements have been of
prime importance to the OTCD markets as CVA
is an adjustment to the fair value (or price) of
derivative instruments.
11
Introduced as part of
Basel III, CVA capital charge corresponds to the
capitalized risk of the future changes in CVA.
CVA capital charge adds significantly to the
cost of trading non-collateralized OTCDs. BCBS
recently issued a consultation paper inviting
comments by October 1, 2015, on proposed
revisions to the CVA framework in order to
better capture exposure risk and align with
other regulatory and accounting practices.
• The liquidity framework was strengthened
by the introduction of two ratios – liquidity
coverage ratio (LCR) to promote short-term
resilience and net stable funding ratio (NSFR)
to address longer-term funding risk. These
have increased funding costs for high quality
liquid assets and accentuated the incorpora-
tion of funding valuation adjustment (FVA) into
the cost of trading.
• The leverage ratio requirements, especially the
U.S. versions – supplementary leverage ratio
3

4. white paper
(SLR) of 3% and the enhanced SLR (eSLR) of
an additional 2% (or 3%) – pose an additional
(tier 1) capital burden by including OTCD
and other off-balance-sheet exposures. The
inclusion of client-facing legs of cleared OTCDs
and the prevention of offsetting by segregated
collateral posted contribute to the total cost of
trading. Being more risk-sensitive, the potential
adoption of the new standardized approach
for counterparty credit risk (SA-CCR) could
mitigate this burden to some extent.
Finally, the uneven progress of cross-border
regulatory implementation has exacerbated
OTCD players’ woes. Some notable examples
include uneven product coverage and availability
of CCPs across various jurisdictions around the
world;12
fragmentation of the liquidity pools as
can be seen in the euro IRS inter-dealer market
where the share of exclusive European dealers in
the market has risen from an average of 73.4%
in the third quarter of 2013 to 94.3% between
July and October of 2014, coinciding with the
introduction of U.S. swap execution facility rules
in October 2013;13
margin period of risk (MPOR)
of two-day net for EU CCPs versus one-day gross
for U.S. CCPs; threshold differences in MRUD
between the U.S. and EU, etc.
Cost of Trading OTC Derivatives
MVA and Cost of Funding for
Centrally-Cleared OTCDs
Margin Valuation Adjustment (MVA)
Toevaluatethetotalcostofclearing,itisimportant
to estimate MVA – the total cost of funding IM and
VM – for the life of a portfolio of trades with a CCP.
The concept is similar to the funding valuation
adjustment (FVA) whose two components are
the cost (funding cost adjustment, or FCA) and
benefit (funding benefit adjustment, or FBA) of
funding hedging strategies for non-centrally-
cleared trades. MVA will also become an integral
part of the funding costs for non-centrally-cleared
OTCD trades when recent regulations compel the
counterparties to start posting IMs.
Similar to FVA for uncollateralized trades, MVA
is the sum of cost and benefit adjustments
arising out of funding the margins. The following
constitute the components of MVA:
• Initial margin cost adjustment (IMCA): Total
cost of funding initial margins.
• Variation margin cost adjustment (VMCA):
Total cost of funding variation margins.
• Variation margin benefit adjustment (VMBA):
Total benefit from the variation margins posted
by the counterparty.
The total MVA, which is a cost to the bank, can
accordingly be defined as:
MVA = IMCA + VMCA – VMBA
IMCA: Cost of Funding the IMs
IM is a capital charge calculated by the CCP daily
and is based on the whole netting set of the client’s
trades with the CCP. So, in principle a new trade
could decrease the margin required to be posted.
It protects the CCP against the closeout risk of a
client portfolio. It was recommended by regulators
that IM be evaluated as a VaR of the portfolio
(e.g., with 99% confidence and a 10-day horizon).
Usually it is calculated as a historical VaR based on
the shifts of underlying market factors.
IMCA can be defined as the expected discounted
cost of funding future initial margins, IM(t). Similar
to FCA, the cost portion of FVA, IMCA is propor-
tional to an institution’s “borrowing” spread SB
which means that the institution borrows funds
at risk free rate + SB
. The cost is calculated over
the life of the transaction or until either the CCP
or the institution defaults, whichever occurs first.
Assuming that there is no wrong-way risk, that
the CCP can’t default and that borrowing spread
is non-stochastic, the expression for IMCA is:
IMCA = –
T
0
SB
(t) · EIM(t) · qI
(t) · p(t) · dt
VMCA = —
T
0
SB
(t) · NEE(t) · qI
(t) · p(t) · dt
VMBA =
T
0
SL
(t) · EE(t) · qI
(t) · p(t) · dt
Where EIM(t) is expected future initial margin, p(t)
is expected discount, and qI
(t) is an institution’s
survival probability.
The biggest challenge in evaluating IMCA is
calculating the expected future initial margin –
EIM(t). Since current-day IM is calculated based
on historical shifts including the most recent
data, IM(t) will be based on market future shifts
up to time t. Brute-force Monte Carlo simulations,
which can incorporate historical data path-wise,
could be used for this but it will be extremely slow
since the portfolio has to be reevaluated at each
time point on each path – around 1,300 times for
a five-year look-back period.
4
The uneven progress
of cross-border regulatory
implementation has exacerbated
OTCD players’ woes.

5. white paper
The following simplifications could be considered:
• Assume that the EIM profile and borrowing
spread are constant in time:
IMCA = SB
* IM * RiskyDurationI
• Assume that EIM reduces linearly to 0 at
portfolio maturity T, i.e. EIM(t) = IM * (1-t/T).
Then a good approximation is:
IMC = SB
* IM * RiskyDurationI
/ 2
• Evaluate EIM(t) by shortening maturities of all
trades by t. After maturities are shortened,
one can use the same historical shifts and
recalculate IM.
• Evaluate EIM(t) by setting the pricing date
at time t and applying some scenarios for
future curves. Then one can apply current-
day historical shifts and recalculate IM. To
gain more efficiency, one can calculate delta
and gamma values (with pricing date set at t)
and apply them to the current day’s historical
shifts. Note that this methodology is consistent
with market practices and with the ISDA SIMM
proposal of using deltas for calculating initial
margins on non-cleared trades.
OnceEIM(t)isevaluated,itcansubstituteexpected
positive exposure EE(t) in the FCA calculator, to
get the total cost of funding initial margins.
VMCA and VMBA: Cost and Benefit of
Funding Variation Margins
Variation margin (VM) reflects a change in P&L
of a client’s netting set with the CCP. VMs can
be positive or negative and can be significant,
depending on market movements. As is the
case with IMCA, evaluation of VMCA and VMBA
constitute an important aspect of the cost of
OTCD trading. Cost arises when mark-to-market
value is negative for the institution, as it would be
required to post VMs to CCP. The institution will
have to borrow money at risk free rate + SB
, and
borrowing spread SB
constitutes the cost for the
institution. Similarly, benefit arises when mark-
to-market is positive as VM posted to the institu-
tion generates cash at lending spread, SL
, which
can be different from the borrowing spread.
To estimate VMCA and VMBA, computations
similar to FVA could be used. In fact, while FCA
(FBA) is a cost (benefit) of funding the hedge
trade, VMCA (VMBA) will be a cost (benefit) of
funding the original trade itself. Thus, VMCA
(VMBA) is proportional to negative (positive)
exposure. Another difference with FVA is that
netting in the case of VMCA/VMBA should be
done on the portfolio of trades with each CCP.
But all other computational aspects of FVA such
as own default risk and WWR should be taken
into account for VMCA/VMBA as well.
Under the same simplifying assumptions as
above, we get for VMCA:
IMCA = –
T
0
SB
(t) · EIM(t) · qI
(t) · p(t) · dt
VMCA = —
T
0
SB
(t) · NEE(t) · qI
(t) · p(t) · dt
VMBA =
T
0
SL
(t) · EE(t) · qI
(t) · p(t) · dt
where NEE(t) is the expected negative exposure
(assumed to be positive). And for VMBA,
IMCA = –
T
0
SB
(t) · EIM(t) · qI
(t) · p(t) · dt
VMCA = —
T
0
SB
(t) · NEE(t) · qI
(t) · p(t) · dt
VMBA =
T
0
SL
(t) · EE(t) · qI
(t) · p(t) · dt
where EE(t) is the expected positive exposure.
Unlike EIM(t) in the case of IMCA, NEE(t) and
EE(t) are much easier to calculate, and are in fact
already part of CVA, DVA and FVA evaluations.
Total Funding Cost of Clearing
To evaluate the total cost of clearing for banks,
MVA, as calculated above, needs to be added to
the cost of the 2% contribution to risk weighted
assets (RWA). One has to be able to calculate it
on an incremental basis for each new trade with
the netting based on the current portfolio with
the CCP. Recently implemented by U.S. regulators,
the supplemental leverage ratio (SLR) increases
capital cost for clearing dealers due to the
inclusion of the exposure of trades they clear for
clients. Some dealers pass on this cost to clients
as an extra fee proportional to the initial margin.
While the contribution of this fee to total funding
cost of clearing might not be that significant for
a single trade, for a large portfolio it can add up
to a substantial amount. Finally, the liquidity ratios
introduced as part of the Basel III regulations –
LCR and NSFR – add to the funding costs of the
trades as they necessitate the funding of high
quality liquid assets (LCR) and stable sources of
capital-like funding.
Recently implemented by U.S.
regulators, the supplemental
leverage ratio (SLR) increases
capital cost for clearing dealers due
to the inclusion of the exposure of
trades they clear for clients.
5

6. 6white paper
Profitability Analysis for Centrally Cleared and
Bilateral IR Swaps
Profitability Analysis for IR Swaps
To analyze the contribution of each cost
component for centrally cleared as well as
bilateral trades, we ran tests for three USD IR
receive-fixed swaps, all with 10-year maturity.
The following scenarios were considered:
• ATM swap coupon C = 2.7%, rates flat 2.7%
(current coupon, current curve).
• ITM swap coupon C = 4.5%, rates flat 2.7%
(legacy coupon, current curve).
• OTM swap coupon C = 2.7%, rates flat 4.5%
(current coupon, increasing rates).
While the ATM scenario reflects costs for new
trades and future rates close to the current
level, ITM can be thought of as a legacy trade,
and OTM is a current trade with rates increasing
to the pre-crisis level. To investigate the effect
of volatility, we ran two volatility scenarios: flat
market vols 25% and flat stressed vols 50%.
To better compare the results, each cost was
converted into a positive par rate adjustment. For
this conversion the following were used – DV01 of
8.74 (rates 2.7%) and DV01 of 8.03 (rates 4.5%).
For calculating default probabilities, counterpar-
ty credit spread of 200 bps, own spread of 100
bps, and recoveries of 40% were assumed along
with the assumption that the CCP can’t default.
For funding costs, FVA and MVA, a borrowing
spread SB
of 1% and lending spread SL
of 0 (i.e.,
there are no funding benefits) were assumed.
Cost of Centrally Cleared Trades
For clearing costs, MVA and a 2% RWA contribu-
tion costs were calculated.
For IMCA, IM was first computed as a 10-day 99%
Monte Carlo simulated VaR. Then an assumption
that EIM(t) reduces linearly to 0 at portfolio
maturity T was considered, leading to:
IMCA = IM * SB
* T/2, where T=10 and SB
=1%
KVA and Cost of Bilateral Trades
For bilateral costs, calculated XVAs comprise BCVA
(bilateral CVA, i.e., CVA-DVA, consider non-nega-
tive), FVA and cost of regulatory capital (KVA).
KVA reflects the total cost of funding capital
requirements defined by RWA (Basel II) and CVA
VaR (Basel III). In general, it also includes capital
costs for funding market risk capital charges, but
in our calculations we assumed that trades are
hedged and market risk is negligible.
Calculating KVA would seem similar to FCA, but
there is no uniformity in the market as to which
capital funding spread SKVA
is to be applied. Most
market participants cite KVA as the biggest
source of pricing disparity. While standard
accounting practice is to multiply the capital
requirement by the return on equity, the same
borrowing spread SB
could be used in order to
have consistency with FCA calculations.
As with EIM(t), it is a highly challenging task to
estimate expected capital requirements at various
times in the future, but one can approximate it using
simplifications described in a section on IMCA.
For calculating RWA, the internal models method
(IMM) was used, and CVA was subtracted from
exposure at default (EAD) as recommended
under Basel III regulations. Then the capital
requirement was calculated as 8% of the RWA.
Cost of RWA capital, KVARWA
, was calculated at
capital funding spread SKVA
which was assumed
to be 10%, using the following formula:
KVARWA = 8% * RWA * SKVA
* T / 2, where T=10
and SKVA
=10%
For evaluating KVACVA
we calculated CVA_VaR
using a standardized-IMM formula assuming a
counterparty rating of BBB and weight 1% and
then applying the following formula:
KVACVA = CVA_VaR * SKVA
* T / 2, where T=10
and SKVA
=10%
Note that CVA VaR calculations were revised in
the consultative document, Review of the Credit
Valuation Adjustment Risk Framework, published
by BCBS in July 2015. This document proposes
replacing current standardized and advanced
approaches with new methodologies that are
more aligned with those set down under the
Basel Fundamental Review of the Trading Book
(FRTB) framework and also with accounting
practices of evaluating CVA.
Costs for Bilateral Trades with Margining
As mentioned in the previous section, starting
September 1, 2016, banks and large nonfinan-
cial institutions will have to post to each other
both IMs and VMs on non-centrally-cleared OTCD
trades as well. This will lead to the reduction
of counterparty risk and hence converging of
funding costs for non-centrally-cleared and cen-
trally-cleared trades. It is expected that there
will be almost no BCVA, FVA and KVACVA
. Instead,
even the non-centrally-cleared OTCD trade costs
will include MVA.

7. 7white paper
While VMCA and VMBA are the same as for
cleared trades, IMCA will be different due to the
evolving standardized initial margin methods.
ISDA published a proposal for the standard initial
margin model (SIMM) in December 2013 and a
revised draft in June 2015.
14
We used the SIMM model, which is based on
weighted risk factor sensitivities, to estimate
initial margin and then applied the same formula
for IMCA as for cleared trades.
SLR and NSFR/LCR Funding Costs
In addition to all the valuation adjustments
described above, we also calculated funding
costs arising from leverage (SLR/eSLR) and
liquidity ratios (LCR and NSFR).
SLR cost is computed by applying the capital
funding spread of 10% over the increase in the
Tier-1 capital requirement which is determined
from potential future exposure (PFE, computed
through the current exposure method), replace-
ment costs and IMs posted in the case of cleared
trades and margined uncleared trades. For
unmargined trades, the IM component is ignored.
The LCR cost is derived by applying the funding
spread of 1% over the net cash outflows
determined from the contractual cash flows
and IM/VM exchanges. The IM exchanges were
ignored for the unmargined trades. The NSFR
cost considers the derivative receivable amounts
net of payables (if receivables are greater than
payables) on top of the IM and default fund
contributions. A required stable funding (RSF)
factor of 85% is applied to IM and default fund
contributions in line with the BCBS guidelines.
The default fund contribution factor is ignored
for margined and unmargined uncleared trades.
IM is additionally ignored for the latter.
The following section outlines the results with
notable observations.
Comparison
1. Across all types of trading, ITM costs are much
higher than OTM and ATM costs, reflecting the
Costs for Cleared OTCD Trades in B.P. Adjustments to Par Spread
Figure 3
ATM IMCA VMCA 2% RWA SLR NSFR/LCR Total
Vol 25% 1.6 2.1 0.5 3.8 4.2 12.1
Vol 50% 3.0 4.1 1.1 7.1 7.0 22.3
ITM
Vol 25% 1.4 0.5 5.5 53.2 8.0 68.6
Vol 50% 2.8 2.3 5.5 51.7 10.6 72.9
OTM
Vol 25% 2.8 8.8 0.0 2.2 8.1 22.0
Vol 50% 5.5 10.5 0.2 3.7 13.3 33.1
Costs for Non-Centrally-Cleared OTCD Trades,
in B.P. Adjustments to Par Spread
Figure 4
ATM BCVA FVA KVA-RWA KVA-CVA SLR
NSFR/
LCR Total
Vol 25% 1.8 1.9 4.6 10.5 3.2 1.0 23.0
Vol 50% 3.6 3.6 9.2 20.9 5.7 1.0 44.0
ITM
Vol 25% 16.0 8.3 47.8 105.3 52.6 5.2 235.1
Vol 50% 17.5 9.9 48.0 106.2 50.4 5.2 237.1
OTM
Vol 25% 0.0 0.4 0.0 0.1 0.9 2.3 3.7
Vol 50% 0.0 2.0 1.1 3.2 0.9 2.3 9.5
Results

8. white paper
higher market value of legacy trades when
rates were higher; OTM and ATM in most cases
are comparable.
2. For ATM trade, doubling vols in general leads
to doubling of all costs except for non-cleared
margined case where SIMM-based IMCA and
NSFR/LCR are volatility independent.
3. Since regulatory-based capital adjustments
– KVA, SLR – are calculated at a 10% funding
spread rather than at 1% as other funding costs,
they dominate costs across all types of trading.
4. For ATM and ITM trades, clearing trades
centrally would be the most profitable. For
bilateral trades, the new margining regime
will provide capital relief. For OTM trades, the
absence of margining obviously impacts the
IMCA and also brings additional transparency
and the controversial NSFR impact. Finally, for
ITM trades, we can see the large CVA capital
charge impact when there is no IM.
Market Evolution
Repricing
As previously seen, many pricing components
have recently been added to the clearing costs
equation: MVA, FVA, RWA, leverage including U.S.
Enhanced SLR, and Federal Reserve extra-charge
for global systematically important banks (G-SIBs).
However, very few market participants are ready
to fully transfer these costs to clients:
• The lower-than-expected and declining volumes
(see Figure 7, next page) imply that efforts to
retain market share continue to be a priority.
• Lack of consistency on the offer side: Which
components should be considered and at what
level to maintain my client base and yet cover
the risks?
• Changing market conditions not being applied
consistently on the offer side creates uncer-
tainty on the client side: Why not always go to
the best price?
Some key market participants – ISDA, JPMC – have
highlighted the “abnormal” costs and suggested
adjustments:
• ISDA in December 2014, in response to the
report on clearing incentives from the OTC
Derivatives Assessment Team (DAT) of the
Basel Committee, expressed the concern that
certain aspects of the leverage ratio potential-
ly render clearing prohibitively expensive for
certain types of clients, thereby creating disin-
centives for banks acting as clearing members.
• JPMC during its Investor Day late February
2015, pointed to the potential exit of key OTC
clearers that are G-SIB or SLR constrained.
• One key logical regulatory evolution is the use
of the SA-CCR
15
that allows firms to offset the
client exposure with their segregated, non-re-
hypothecable collateral, versus the current
CEM which does not.
Overall, the market is still unclear. However, a slow
but significant repricing seems inevitable.
• Only one major player is said to have applied
a four-fold increase to its prices, but not for all
the clients.
16
• The phase-in of IM/VM requirements for
bilateral trades from 2016 (MRUD) should also
bring some balance and increased volumes to
the cleared world.
Costs for Non-Centrally-Cleared OTCD Trades with Margining
Figure 5
ATM IMCA VMCA KVA-RWA SLR NSFR/LCR Total
Vol 25% 2.3 2.1 4.6 5.0 5.5 19.4
Vol 50% 2.3 4.1 9.2 7.5 5.5 28.5
ITM
Vol 25% 2.4 0.5 47.8 54.7 9.9 115.3
Vol 50% 2.4 2.3 48.0 52.5 9.9 115.1
OTM
Vol 25% 2.1 8.8 0.0 2.7 6.1 19.7
Vol 50% 2.1 10.5 1.1 2.7 6.1 22.5
Summary Table
Figure 6
OTC type ATM ITM OTM
cleared 12.1 68.6 22.0
non-cleared 23.0 235.1 3.7
non-cleared margined 19.4 115.3 19.7
8

9. 9white paper
• This is evidenced in Figure 6 (previous page) for
new ATM trades with no incentive to clear and
obviously less operational complexity. Hence,
the research by many buy-side firms to stay
under the radar of regulatory thresholds.
Exchange-Traded Derivatives (ETD):
• Owing to recent OTCD reforms, which are
still ongoing for large parts in Europe and for
bilateral trades globally, little attention has been
given to the changing ETD environment.
• The growth of swap futures, which can be more
attractive than OTCDs by virtue of their shorter
close-out period (two days versus five days), has
been one of the most visible events.
• However, the introduction of capital require-
ments for clearing brokers, regardless of the
nature of the trade (ETD or OTCD), has been a
key negative event for ETD clearing, as margins
are narrow with little room for integrating an
additional risk buffer.
• Among other factors, the above have acceler-
ated the “merger” of ETD and OTCD clearing
businesses at major providers.
Market Evidence
• Decreasing volumes and stable cleared-to-
uncleared ratio:
>> As experienced by market participants and
evidenced in Figure 7, OTCD volumes have
decreased approximately 26% between
January 2014 and August 2015.
>> The cleared-to-uncleared volumes ratio is
stable at around 60%, albeit far from the
initial target of 75% to 80%, which proves
the lack of regulatory incentives to clear
centrally. Again, a significant evolution would
materialize only after the start of the MRUD,
which was recently postponed to September
2016.
• Client collateral requirements: OTCD increase
and ETD stabilization.
>> While client collateral requirements can vary
for many reasons, including market volatility
in CCP risk models, the client collateral for
OTCDs have more than doubled in 20 months,
despite the volume decrease (see Figure
8, next page). This confirms an ongoing
repricing in parallel with significant market
shares’ developments between the main
futures commission merchants (FCMs).
>> Meanwhile, client collateral for ETDs has only
increased a little over 3% to $165 billion in
August 2015, compared with $160 billion in
January 2014. This highlights that there is
minimal room for price improvement in a very
mature market with stable market shares.
Resulting Revenue Models, Market Structure
• Business strategies – from market share acquisi-
tion to profitability:
>> In line with any new market, the capital-inten-
sive OTCD clearing business has experienced
a classical initial hunting phase, but with
Gross Notional Outstanding: IR OTCDs (in Billions of U.S. Dollars)
Source: CFTC
Figure 7
Jan-14 Aug-15
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
Cleared Uncleared Total
v 24%
v 29%
v 26%
206,744
156,116
136,572
97,337
343,316
253,453

10. 10white paper
some key differentiation between two groups
of market participants:
»» Large broker dealers entered the market
to first protect their trading market shares
and discounted the prices for clients that
traded and cleared at the same shop.
»» Securities services firms were also trying
to capture market share as they were
betting on their collateral management
services to offset some of the costs.
>> Unfortunately, the lack of volumes growth
combined with increased regulatory costs
have seriously hurt the initial business plans.
»» Several key names have already left the
market or significantly reduced their
service offering – e.g., BNY Mellon, State
Street, RBS, Nomura, who all had less than
1% market share in 2014.
»» For other participants, it is an endurance
race with limited complementary strategic
options: internal and external consolida-
tion, price increase and hope for some
regulatory adjustments.
• Clients’ reactions and adaptation:
>> One could obviously argue that clients
would:
»» Reduce their derivatives’ usage: this is
currently the case but will remain limited
given hedging requirements.
»» Flight-to-cheapest FCMs: This will be
temporary, as regulatory costs will need
to be embedded by all FCMs sooner or
later. Additionally, the largest FCMs will
pose concentration risks that need to be
factored in.
>> The MRUD implementation will eventually
force clients out of the bilateral world and
into the cleared world. This will, however,
take time.
• Alleviation tactics:
>> Ever since the announcement of various
rules, banks and other market participants
have been trying to persuade regulatory
authorities to attenuate the impact.
»» For example, industry groups have been
lobbying for a change in the treatment
of client collateral in the leverage ration
computation (to permit margin offset).
>> In the meantime, several players are devising
other ways to circumvent the problem:
»» De-recognition of client margins on the
balance sheets. However, this would mean
legal isolation and passing on the interest
earnings to clients.
»» Treatment of variation margin as
settlement – as opposed to collateral.
This could potentially lead to signifi-
cant reduction in the leverage and risk-
weighted capital due to reduced effective
maturity (to the settlement date) and
thereby PFE. In fact, major CCPs have
already sought approvals for the same.
The success of such a conceptual change
would require addressing concerns over
things like price alignment interest that
is currently paid by margin receiver on
interest earned from the posted margin.
>> Regulators seem to be responding to some
of these concerns, instilling hope that there
might be light at the end of the tunnel.
Share ofFundsin Cleared Swap Segregationof a Player vs. Total Such Funds
Source: CFTC
Figure 8
18%
16%
15%
11% 10%
9%
5%
4% 3% 3%
9%
20%
11%
12%
16%
7%
4%
6%
8%
2%
0%
5%
10%
15%
20%
25%
Jan-14 Aug-15
BARCLAYS
CAPITAL INC
CREDIT
SUISSE
SECURITIES
(USA) LLC
CITIGROUP
GLOBAL
MARKETS
INC
JP MORGAN
SECURITIES
LLC
MORGAN
STANLEY &
CO LLC
GOLDMAN
SACHS & CO
DEUTSCHE
BANK
SECURITIES
SECURITIES
MERRILL
LYNCH
PIERCE
FENNER &
SMITH
WELLS
FARGO
SECURITIES
LLC
UBS
SECURITIES
LLC

11. 11white paper
Footnotes
1
Yet to start in Europe.
2
The Dodd-Frank Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) is considered
the most comprehensive regulatory reform of the financial sector in the U.S. Mandatory central clear-
ing of the standardized OTC derivatives formed a major constituent of the swaps marketplace reform
initiatives of the Dodd-Frank Act. http://www.cftc.gov/lawregulation/doddfrankact/index.htm
3
The European Markets Infrastructure Regulation (EMIR) came into force on August 16th
, 2012, introduc-
ing requirements aimed at improving the transparency of OTC derivatives markets and to reduce the
risks associated with those markets. It includes the obligation to centrally clear certain classes of over-
the-counter (OTC) derivative contracts through CCPs or apply risk mitigation techniques when they
are not centrally cleared. http://www.esma.europa.eu/page/OTC-derivatives-and-clearing-obligation
4
Basel Committee on Banking Supervision (BCBS), a standing committee of the Bank for International
Settlements (BIS); IOSCO – Board of the International Organization of Securities Commissions.
5
The initial margin requirements for the covered entities is phased in based on their aggregate month-
end average notional amount of non-centrally-cleared derivatives activity. As per the revised time-
lines from the Basel Committee on March 18th, 2015, entities with notional greater than €3.0 trillion
need to comply from Sept. 1st, 2016, followed by those greater than €2.25 trillion from Sept. 1st, 2017,
€1.5 trillion from Sept. 1st, 2018, €0.75 trillion from Sept. 1st, 2019 and all covered entities starting
Sept. 1st, 2020. The phase-in for variation margin requirements start from Sept. 1st, 2016, for those
covered entities with greater than €3.0 trillion notional and all covered entities from March 1st, 2017.
http://www.bis.org/bcbs/publ/d317.htm
6
http://www.bis.org/publ/bcbs282.htm
7
The Committee on Payments and Market Infrastructures (CPMI), a standing committee of Bank for
International Settlements (BIS).
8
The clearing member’s exposure to client needs to be capitalized as per CCR standardized (SA-CCR) or
internal models (IMM) approach, as applicable.
9
https://www.bis.org/cpmi/publ/d101.htm
10
http://www.bis.org/press/p150709.htm
11
http://www.bis.org/bcbs/publ/d325.pdf
12
http://www.fsb.org/wp-content/uploads/OTC-Derivatives-10th-Progress-Report.pdf
13
http://www2.isda.org/news/cross-border-fragmentation-of-global-derivatives-end-year-2014-update
14
http://www2.isda.org/functional-areas/wgmr-implementation
15
CEM: Current Exposure Method; SA-CCR: Standardized Approach for measuring Counterparty Credit Risk.
16
Risk Magazine, May 24th, 2015.
»» It has been claimed that the Basel
Committee will soon consult on moving
from CEM to SA-CCR for leverage ratio
computation. SA-CCR being more risk-
sensitive is expected to result in reduced
derivative exposures.
Conclusion
The fast-changing regulatory landscape increases
clearing costs and therefore trading costs to an
extent that had not and could not have been
anticipated by the market, given some late and
impactful regulatory reforms. This is evidenced
by recent market exits of major financial institu-
tions, repricing which is currently taking place,
leveraging and active applied research for
analyzing and formalizing various costs – MVA,
RWA, leverage, FVA, etc.
Once the derivatives reforms are complete, on a
global level and for both uncleared and cleared
derivatives, one can expect cleared volumes to
pick up and market prices to adjust. Meanwhile,
we can assume that a few more renowned insti-
tutions will need to exit the market, leading to
additional consolidation.

12. About the Authors
Serge Malka is the Capital Markets and Risk Practice Co-Leader for Cognizant Business Consulting
in North America. He specializes in derivatives trading and risk management. Serge has conducted
many organizational, regulatory and IT projects with a strong European footprint. His recent regulatory
work focused on EMIR/BIS IOSCO, DFA, Basel III, Fundamental Review of the Trading Book (FRTB), and
the U.S. Fed FBO regulations. Since 2014, Serge’s work has focused on the derivatives overall costs’
evolutions, including a conference in Paris with Quantifi, Axa IM, HSBC and Vivescia. He can be reached at
Serge.Malka@cognizant.com.
Dmitry Pugachevsky is Director of Research at Quantifi, responsible for managing its global research
efforts. Prior to joining Quantifi in 2011, Dmitry was Managing Director and head of Counterparty Credit
Modeling at JP Morgan. Before starting with JP Morgan in 2008, Dmitry was Global Head of Credit
Analytics at Bear Stearns for seven years. Prior to that, he worked for eight years with analytics groups
of Bankers Trust and Deutsche Bank. Dr. Pugachevsky received his Ph.D. in applied mathematics from
Carnegie Mellon University. He is a frequent speaker at industry conferences and has published several
papers and book chapters on modeling counterparty credit risk and pricing derivatives instruments. He
can be reached at Dpugachevsky@quantifisolutions.com.
Rohan Douglas is CEO of Quantifi. He has over 25 years of experience in the global financial industry.
Prior to founding Quantifi in 2002, he was a Director of Research at Salomon Brothers and Citigroup,
where he worked for 10 years. He has extensive experience working in credit, interest rate derivatives,
emerging markets and global fixed income. Rohan is an adjunct professor in the graduate financial
engineering program at NYU Poly in New York and the Macquarie University Applied Finance Centre
in Australia and Singapore. He is the editor of a book, “Credit Derivative Strategies,” published by
Bloomberg Press.
Krishna Kanth Gadamsetty is a Senior Consultant within Cognizant’s Banking and Financial Services
Consulting Group, working on assignments for leading investment banks in the risk-management domain.
He has more than seven years of experience in credit risk management, capital markets and information
technology. Krishna is a Financial Risk Manager – certified by the Global Association of Risk Profes-
sionals — and has a postgraduate diploma in management from the Indian Institute of Management,
Lucknow. He can be reached at KrishnaKanth.Gadamsetty@cognizant.com.
S L K Prasad Thanikella is a Senior Consultant within Cognizant’s Banking and Financial Services
Consulting Group. He has more than seven years of experience in financial risk including implementa-
tion of complex regulations such as regulatory capital rules under Basel III, capital adequacy, capital
buffer measurement and management. He is a Financial Risk Manager certified by the Global Associa-
tion of Risk Professionals (GARP), a gold standard in financial risk management. He has an M.B.A. with
specialization in finance. He can be reached at Santoshlakshmikiranprasad.Thanikella@cognizant.com.
12white paper

13. About Quantifi
Quantifi is a specialist provider of analytics, trading and risk management solutions. Our suite of integrated
pre- and post-trade solutions allow market participants to better value, trade and risk-manage their expo-
sures and respond more effectively to changing market conditions. Founded in 2002, Quantifi is trusted
by the world’s most sophisticated financial institutions including five of the six largest global banks, two
of the three largest asset managers, leading hedge funds, insurance companies, pension funds and other
financial institutions across 16 countries. Renowned for our client focus, depth of experience and com-
mitment to innovation, Quantifi is consistently first-to-market with intuitive, award-winning solutions.
Contact us at www.quantifisolutions.com.
About Cognizant
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mately 219,300 employees as of September 30, 2015, Cognizant is a member of the NASDAQ-100, the S&P
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