OTC derivatives may repeat equity market fragmentation errors
Plans by the London Stock Exchange (LSE) to open a trade repository for OTC derivatives suggest intensifying competition between infrastructure providers ahead of new swap clearing requirements, but indemnification disputes have also prompted fears of equity-style data fragmentation.
The new repositories will be a central peg of the industry’s efforts to fulfil obligations under the US Dodd-Frank Wall Street Reform and Consumer Protection Act, the proposed European market infrastructure regulation (Emir) and other financial oversight mandates which collectively enact the G20 leaders’ recommendation to move as large a proportion of OTC derivative trading activity as possible onto centrally cleared, exchange-like platforms.
Trade repositories work as giant databases which hold the underlying data on OTC derivatives trades, allowing regulators to observe market positions and identify concentrations of risk. But the establishment of a network of overlapping repositories could undermine the systemic risk benefits that centralised clearing is meant to provide.
“A proliferation of local repositories would inevitably lead to data fragmentation, which would make it extremely difficult for regulators to quickly obtain a full picture of any particular asset class to evaluate risk concentrations,” said Larry Thompson, general counsel at the Depository Trust & Clearing Corporation (DTCC), a non-commercial cooperative serving as the US’s primary post-trade infrastructure organisation.
A particular cause for apprehension is Dodd-Frank’s requirement that US-based repositories must obtain indemnification from foreign regulators before sharing market data with them. “Overseas regulators have told me that they are unlikely to enter into these agreements,” said Thompson, asserting that non-US watchdogs are balking at Dodd-Frank’s extraterritorial reach.
A single view
Last week UnaVista, the LSE’s hosted matching, reconciliation and data integration service, revealed it was in talks with UK regulator the Financial Services Authority to launch a trade repository for OTC derivatives. In preparation for the offering, the exchange group bought the FSA’s Transaction Reporting Service earlier this year and is presently migrating users to UnaVista.
“There is currently some regulatory uncertainty over central counterparty and repository connectivity, as well as the requirements for increased regulatory reporting,” said Mark Husler, head of business development at UnaVista. “Added to this, trading patterns are changing. Volumes are increasing and assets are diversifying – both by asset class and geography. All this requires a global system that is flexible, scalable and can handle multiple asset classes.”
The global interest rate derivatives market was estimated at US$553.8 trillion in notional outstanding in June 2011 by the Bank for International Settlements. On 7 December, the DTCC announced plans to locate a trade repository for the market in London, with data from 15 of the largest global dealers.
“Without an indemnity agreement, US-based repositories may be legally precluded from providing data to global regulators – most likely spurring these same regulators to create their own local repositories to avoid indemnification,” said Thompson.
Deriv/SERV, a DTCC subsidiary that offers solutions for automating OTC derivatives, already operates global trade repositories for credit default swaps and OTC equity derivatives and has mooted a foray into FX and commodities OTC derivatives markets. While the interest rate repository will initially focus primarily on voluntary regulatory reporting commitments of the largest OTC interest rate dealers, in 2012 DTCC will expand its systems to support Dodd-Frank trade reporting requirements and additional buy-side trade reporting requirements as additional global regulations emerge.
“Major source” of fragmentation
Jeff Gooch, CEO of MarkitSERV, a single gateway for global OTC derivative transactions processing jointly owned by financial information services company Markit and the DTCC, agrees that too many trade repositories could be a “major source” of fragmentation. “Transaction reporting needs to be efficient and with different jurisdictions requiring their own trade repositories, some trades could be reported twice. This will make it harder to ascertain how much trading is actually being executed and what is your exposure.”
And while the US was able to start with a blank sheet of paper and create transaction reporting for swaps from scratch, the situation in Europe is more complicated. The Markets in Financial Instruments Directive (MiFID) laid down transaction reporting obligations in 2007 and Gooch says questions remain over how extra reporting obligations will be harmonised under EMIR.
“Competition is good for the market, but the ideal would eventually be to have as small a number of trade repositories as possible,” said Gooch, noting that while post-trade reporting might face added complexity, real-time reporting could be a “bigger issue” where there was the possibility of duplication with the result of inflating perceived liquidity.
“In Europe, after four years, we still don't have a consolidated view of cash equities and the path we seem to be taking for derivatives is the same. If we failed in equities, we will most certainly fail in derivatives,” said Gooch.