By Philip Stafford
Gone in 1.932 seconds. That’s how long it took for a group of swap market participants and CME Group, the world’s largest futures exchange, to execute and clear 21 off-exchange trades totalling a notional $4.1bn last month.
It was a piece of one-upmanship typical of an industry obsessed by speed but it also encapsulated a dramatic change the industry is still feeling its way around – the impact of moving swathes of the vast $6tn over-the-counter derivatives (OTC) market on to electronic venues and through central clearing.
“Due in part to the sheer size of the market, the migration of OTC derivatives to exchange trading and central clearing will change financial relationships to the greatest extent since the electronification of equity trading in the 1980s and 1990s,” says Rob Hegarty, global head of market structure at Thomson Reuters, the financial information provider.
The catalyst for the change is a mandate from the G20 group of economies in 2009, keen to strengthen the global financial system in the wake of the collapse of Lehman Brothers. Policymakers cited the opaque OTC market as a key factor exacerbating market instability. Sweeping legislation such as the Dodd-Frank act in the US and the European Markets Infrastructure Regulation, passing through European lawmakers, are designed to strengthen critical market infrastructure.
Among the changes, the Commodity Futures Trading Commission, the US regulator, has proposed that participants execute and clear OTC trades “as soon as technologically practicable”.
The new rules have sparked a flurry of technology projects around the world as exchanges, banks and institutional investors build technology infrastructure capable of handling the changes. A tie-up between BM&F Bovespa and software makers Cinnober and Calypso Technologies in November was only the latest in a string of projects being undertaken by many of the world’s largest exchanges.
But some argue that in one crucial respect, policymakers were pushing at an open door.
At the same time banks and institutional investors have grown to realise that understanding their risk exposure during the trading day at any moment has become an imperative rather than a luxury.
“As volatility alone can cause rapid intra-day deterioration of major counterparty credit quality, a move towards near-time or real-time clearing is inevitable anyway,” said Kevin McPartland, fixed income analyst at Tabb Group, in a report last year.
It marks a radical departure for an industry that negotiated trades bilaterally between counterparties, usually investment banks. The effects could be profound.
For a start, the technology will have to manage huge amounts of complex data to calculate both initial margin and variation margin as fast as possible. Valuing an OTC credit default swap is far more complex than valuing a standard interest rate swap. Unlike exchange-traded instruments, OTC derivatives were frequently never intended for clearing and processing.
Furthermore market participants may have to hold more funds in reserve to meet any intra-day margin calls, while clearing houses may require more capital to protect themselves. Traders of OTC derivatives, such as brokers and buyside firms, have not historically had to put up margin for clearing. Tabb estimates, as a worst case scenario, that the industry may need to come up with $2tn in capital.
“Due to the onerous membership and operational requirements tied to becoming a direct clearing member of a central counterparty, the vast majority of fund management firms will elect to clear their derivatives through general clearing members,” says Marianne Brown, chief executive of Omgeo, the post-trade services group.
“The fees associated with using a clearing broker, along with the increased margin requirements from the central counterparties, will likely increase the overall cost of doing business for fund management firms.”
The threat of increased costs in straitened times leads many to predict that market participants will look for ways to streamline operations that tie-up large amounts of collateral. Clearing cycles may be completed intra-day. Currently the system can take several days.
If central counterparties lower margin and collateral requirements to gain market share, Mr Hegarty warns it could raise systemic risk. It will “reduce the ability for that central counterparty to absorb a counterparty failure,” he says.
But while exchanges, banks and clearing houses try to get a better view of potential risks in the financial system, there has been a mixed response from end users – institutional investors. Larger firms have begun IT upgrades, but many smaller ones are waiting for further clarification over the final rules.
“In the new clearing environment, it will become essential for fund management firms to have a near real-time consolidated view of their counterparty exposures across both their bilateral and centrally cleared portfolios,” says Ms Brown.