Driving in the dark
much planning can the buy-side actually do right now when it comes to
Although the basic principles of new OTC
derivatives regulation are well understood, the fact that many of the finer
points are yet to be determined means detailed assessments of brokers by the
buy-side is still a bit tricky.
We all know swaps will be standardised
where possible so they can be traded on exchange and centrally cleared, but
institutional investors are still waiting for clarification on exactly which
types of derivatives the new rules will cover, how trading venues will operate
and detail on collateral requirements.
This work is currently being carried out by
the Securities and Exchange Commission and Commodity Futures Trading Commission
in the US and the European Securities and Markets Authority in Europe.
The reality is that with the rules
scheduled to come into force by the end of this year, the window that the
buy-side has to conduct detailed analysis of their relationships trading
partners is slowly closing.
some of this analysis must have been carried out already? What about the health
of bilateral relationships after the financial crisis?
Since the collapse of Lehman Brothers,
monitoring the safety of counterparts for derivatives transactions has prepared
the buy-side well for those exotic swaps that cannot be standardised.
These swaps will be subject to increased
and more formal capital charges under the new rules.
More recently, the increasing number of banks
that are being downgraded means many traditional investment houses that need to
hold long-dated swap positions need to ensure the length of their exposures do
not exceed the expected life of their counterparties.
The buy-side therefore needs to take a
close look at data related to their counterparties, such as credit default swap
spread levels, volatility of share price movements and the costs associated
with replacing counterparties for long-duration swaps.
The cost of not monitoring counterparties
was brought into sharp focus late last week as Goldman Sachs revealed that if
its credit rating were cut by two notches it would be required to find an extra
US$2.2 billion worth of collateral.
However, as we move into the new,
clearable, world, it won’t just be about counterparty safety…
what are the other counterparty issues? How much thought needs to be given to
trading and connectivity?
It may help to think of trading and
connectivity aspects similarly to choosing counterparties for trading equities.
In Europe and the US, moving swaps on
exchange also comes with fragmentation, with the new rules facilitating the
creation of venues that will see liquidity split across a number of different
markets. Your broker therefore needs to have connectivity to those markets –
swap execution facilities in the US and organised trading facilities in Europe
– that a buy-side firm requires. Again, the lack of certainty on what products
will be eligible for clearing and the different products that trading venues will
target makes preparation difficult.
Derivatives are also global products, and
counterparts will also need to demonstrate an understanding when a trade falls
under the US or European legislation.
will also need to manage collateral requirements in the new world – how does
this change who the buy-side trades with?
In addition to counterparty safety and
ensuring that your broker is fit enough to handle margin requirements, buy-side
firms could also make more use of brokers’ prime services, in particular their
ability to offer collateral transformation services.
The need for collateral transformation – whereby
a firm is able to substitute one type of asset for another in order to meet
margin requirements – is becoming more important, particularly given that
sovereign bonds that were once regarded as appropriate for meeting margin
requirements are no longer considered as safe as they once were.
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