The global reforms to the trading, clearing and settlement of over-thecounter (OTC) instruments have been well published and there is a pleasing level of industry awareness over both the requirements and the likely implications to business operations. However, many consequences of the reforms are yet to be fully identified and there is the risk that the far-reaching nature of these changes could have material consequences on the ability of local managers to use these instruments in the future. In an extreme example, the indirect consequences of these reforms could spell the effective end of the OTC market for many investment managers.
Background to reform
As a consequence of the global financial crisis, in April 2009 the G20 signed a declaration on strengthening the financial system. This was based on the view that the growth of the relatively unregulated OTC market had contributed to the crisis through a lack of transactional transparency and standardisation. In short, financial institutions and their counterparties needed supervision. In June 2012 the G20 reaffirmed its commitment to overhaul OTC derivative trading and defined a vision for what this would entail:
“OTC derivative contracts should be traded on exchanges or electronic trading platforms and cleared through central counterparties by the end of 2012. In addition, OTC derivative contracts should be reported to trade repositories and subject to higher capital requirements when non-centrally cleared.”
Overview of changes
While the nature of OTC instruments are inherently complex and require deep expertise in financial markets to be properly understood, the main components of reforms articulated by US and European regulators are relatively straightforward and can be broken into the following components:
• all standardised OTC derivatives should be traded on exchanges or electronic platforms where appropriate
• all standardised OTC derivatives should be cleared through central counterparties
• OTC derivative contracts should be reported to trade repositories, and
• non-centrally-cleared derivative contracts should be subject to higher capital requirements.
The timing of these reforms depends on the size of the market participant but generally most investment managers will be required to comply with them by the end of 2013. The Australian regulators have adopted a wait-and-see approach and have fallen short of mandating central clearing or use of exchanges and trading platforms for Australian-issued securities. However, as will be explained, the global reach of offshore regulations, particularly those emanating from the US, will mean that local investment managers may be caught out by the more rigorous offshore regulations.
Implications of global reforms
The application of global, particularly US, reforms is yet to be fully understood and it is possible that the actual outcome may be more or less far reaching than the current view. However, the following summarises the current view on how these regulations may apply to non-US-based investment managers.
• Trading with a US-based counterparty will be subject to US regulations.
• Trading with a US-owned counterparty (owned by a US-based financial institution) will also likely be impacted, even if the trade is with a non-US trading desk, such as one operated out of Australia.
• Trading with a swap dealer (SD) or major swap participant MSD) will also likely require compliance with US regulations even if the counterparty is not US-owned and/or the instrument traded is not US-domiciled.
While it is not yet known what local counterparties will fall into these categories, it is understood that most major local banks are registering in order to enable them to trade US-based OTCs. Another way to look at this is that to avoid the reach of US regulations, the counterparty will need to be not based in the US, not owned by a US organisation and, potentially, not registered as an MSD or SD. On this basis, the list of counterparties, and therefore instruments, not covered by US regulations looks pretty limited.
Consequences of compliance
So what does it mean to comply with global regulations and how significant is this to local investment managers? Most significantly, if an investment manager trades an OTC that is considered standard, it will fall onto the list of securities that require central clearing. In this case, in order to trade the security, the investment manager will need to find and appoint a central counterparty clearer (CCP) in much the same way futures and other listed derivatives are cleared.
Sounds pretty simple? In theory, yes, but there may be some real practical implications. Firstly, the commercial viability of the CCP model has not yet been demonstrated and some counterparties have already expressed their reluctance to provide this service to all but the largest buy-side clients. So, if you are a small investment manager wishing to trade a certain security that falls on the list requiring you to use a CCP, you may find that you are out of luck for the simple reason that CCPs don’t want your business.
Secondly, by moving to a CCP model, the rules around the quality of collateral will no longer be decided between the counterparties, but instead will be enforced by the CCP. In many cases this will require a higher standard of collateral to be provided and many investment managers, particularly those sitting on limited cash or fixed-income reserves may find that they can’t access the collateral required by the CCP. Perhaps this will be solved by accessing high quality bonds through the repo market, but again there is evidence of reluctance by the banks to lend out these securities for this purpose. Also, under the US regulations, these enhanced collateral requirements may also apply even if the securities traded are not subject to central clearing.
Finally, even if the investment manager is able to access the required collateral, these enhanced requirements alter the economics of the transaction, particularly for those instruments that were not previously subject to collateral obligations.
As part of this survey, Bridge undertook a survey of 22 managers to assess their views on the likely impacts of OTC reforms and the results of this survey suggest that, while there is a good understanding of the pending reforms, there is similar concern on the indirect implications. Of the managers surveyed, 38 per cent had a deep understanding and 62 per cent had at least a partial understanding of the reforms. Twenty-five per cent thought that access to appropriate collateral was either a “moderate” or “significant” issue.
Interestingly, most respondents did not express concern regarding their ability to access CCP arrangements. That appears to be slightly contradictory to the statements made by providers regarding their intended focus on larger market participants.
So, what does this mean for the future of OTC trading? It is clear that global regulations have far-reaching implications to the local market and largely dilute the stance taken by local regulators. Once investment managers fall into the regime they will essentially move into a standardised model that is analogous to the listed-derivatives process and those instruments that remain outside may become uneconomic. So the question remains, do OTC reforms spell the end of the OTC market for investment managers?
Bruce Russell and William Wenkart are consultants at Bridge, a specialist advice and project-delivery firm to the financial services industry.