The rising cost of tailoring
the standardisation of OTC derivatives reduce the opportunities for institutional
investors to find contracts that can meet their specific needs?
Almost inevitably, buy-side firms will lose
a degree of control over how they manage risk if it becomes harder to find a
customised OTC contract that will cover the exact exposure a firm wishes to
The potential risks to market stability
stemming from the lack of standardisation of OTC contracts are a key concern for
regulators in both Europe and the US. As such, the European market
infrastructure regulation and the Dodd-Frank Act respectively seek to determine
which contracts are suitable for trading on exchange-like platforms and
centralised risk management via clearing houses.
Under the new rules, bespoke instruments used
by the buy-side to hedge certain exposures that are not suitable for
standardisation will be subject to increased capital charges, meaning their
continued use will require careful consideration.
hedging becomes less exact, could the new rules actually increase risk levels
for some investors?
By transferring OTC instruments onto
centrally-cleared platforms, counterparty risk is supposedly reduced, so the
net level of risk for all market participants decreases. That said, market
participants argue the ability of firms to reduce their own risk will be
impaired if instruments that remain OTC become more expensive.
Ultimately, the new rules seek to protect
the market against the kind of chaos that descended on the OTC market in the
aftermath of Lehman Brothers’ collapse, but it is still up to individual firms
to ensure their own risk level does not get out of hand.
much more will the buy-side have to pay to use the more exotic OTC instruments
than for those swaps that migrate to exchange-like venues?
It’s too soon to tell, but last week the
European Parliament voted through its version of the Basel III capital and
liquidity requirements. The European Parliament’s Economic and Monetary Affairs
Committee agreed that systemically important banks will be required to hold an
additional capital buffer of 3% - which can be increased to 10%, if deemed
Market participants will be faced with a
choice over how much to spend on their own risk. They can either opt to use a
standardised OTC instrument, listed future or option that may constitute a less
than perfect hedge, or they can obtain a customised bilateral instrument that
will cost considerably more.
swaps move on exchange, how will the resulting fragmentation affect the cost of
doing business for investors?
Fragmentation could become an issue as new
organised trading facilities (OTFs) in Europe and swap execution facilities
(SEFs) in the US are established. Nobody yet knows how many such facilities
there will be – so its difficult to predict just how fragmented the new OTC world
In the US, regulator the Securities and
Exchange Commission has said SEFs
could take the form of a request-for-quote (RFQ) system – where participants
define the contract they require and request a price from a number of
participants – or a limit order book system – leading to further uncertainty.
In Europe, a greater
number of multilateral trading facilities, organised trading facilities and
systematic internalisers is also expected to emerge as the new derivatives
rules reach the implementation phase.
However, market participants have argued
that most of the liquidity will quickly migrate to a smaller number of successful
venues, with the remainder falling by the wayside – just as they did for
equities. Naturally, for the more liquid instruments, initially at least, a
larger number of new platforms will rush onto the scene than for lower-volume
Others point out that in today’s OTC
markets, we already have a degree of fragmentation, since buy-side firms need
to choose between brokers when negotiating their OTC contracts bilaterally. The
establishment of a large number of SEFs and OTFs would impact liquidity in the
short term, but those who argue that market forces will create an equilibrium
insist that the benefits outweigh the short-term costs.
here to vote in this month’s poll.