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ICAP recommends reforms to OTC

A recent report argues the OTC market should improve price transparency but should not move to an exchange traded basis, says Lynn Strongin Dodds

Whenever there is a financial crisis, the over the counter (OTC) derivatives market is thrust into the spotlight.Recommendations and changes have typically been made over the years but the instruments have always been allowed to slip behind the exchange traded scenes. This will not be the case in the current financial crisis. These instruments, which are seen as contributing to the collapse of Lehman Brothers and the overall fragility of the financial market, are top of the policymakers' agenda.

When the markets started to plunge this past autumn, most of the attention was centred on credit default swaps (CDS), a roughly $60trn (€45.7trn)  world-wide market. Swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt, but they are also bought and sold as bets against bond defaults, with hedge funds being major players. Now, though, regulators are casting their eyes across the entire OTC spectrum.

The past few months has seen the G20 group of nations as well as the European Commission calling for greater transparency. In addition, the International Swaps and Derivatives Association (ISDA), along with the Operations Management Group, the Managed Funds Association and the Asset Management Group of the Securities Industry and Financial Markets Association have joined forces. Their goal is to improve the OTC processing environment by significantly reducing systemic risk and increasing transparency. They wrote to Timothy Geithner, president of the New York Federal Reserve and US Treasury Secretary nominee, recommending a raft of proposals. They included the publication of Master Confirmation Agreements to harmonise equity derivative transactions and trade processing, as well as best practices and guidance notes, relating to individual asset classes and collateral matters.

Not surprisingly, perhaps, banks and brokers are busy trying to protect these private trading arrangements while derivatives exchanges are hoping to make inroads into this bountiful marketplace. There is a view that the trading of key CDS contracts could be moved onto exchanges as the pressure mounts for a more transparent marketplace.

The overriding fear, though, in many quarters of the industry is that regulators will follow the example of the US in the wake of the corporate scandals early this decade and apply too heavy a hand. The outcome in the form of Sarbanes Oxley has been widely criticised as an over-burdensome piece of regulation that imposed costly and unneeded obligations on issuers.

"There is no doubt that there will be closer oversight of the OTC markets, but the regulators must be proportionate in their response," says Anthony Belchambers of the London-based Futures and Options Association. "Banks and their customers will be scaling back on risk, leverage and complexity. That said, markets must continue to be liquid, innovative and competitive - and that includes sustaining financial trading in commodity markets. We need to be particularly careful to focus now on the kind of markets we want to have in five to 10 years' time."

A recent report published by ICAP echoes these sentiments. The London-based inter-dealer broker stated that while the OTC markets were not the root cause of current market problems, the lack of transparency in some parts of the OTC world may have exacerbated the situation.

It noted that there will be a regulatory overhaul and in certain areas that could be significant, but warned against the temptation "to mandate the transfer of OTC trading on to exchanges". ICAP argued that an exchange solution would "needlessly grant the exchange a monopoly on trade execution, leading to restricted access to clearing".

Also, as pension consultants point out, institutional investors look to the OTC markets for bespoke solutions. Their appetite may be diminished but they are expected to return once financial conditions stabilise. Pension funds have been big participants in the OTC markets over the past few years as many, particularly in the UK and Netherlands, have been proponents of liability driven investment strategies, which incorporate instruments such as inflation and interest rate swaps to hedge exposures.

"I do not think we will see a major shift to exchange-traded instruments because institutions still want tailor-made solutions, which is the main attraction of OTC derivatives," says Max Verheijen, managing director of the structuring team at Cardano, the risk and derivatives specialist based in Rotterdam.

"Due to the many details to agree on in OTC contracts it is difficult to automate these products...What we are seeing, though, is that institutions will be more careful about who their counterparties are and the way they manage collateral. The real problem today is the lack of liquidity, which makes transferring risk markets difficult. In the end, however, the derivatives markets are the only place to transfer risks efficiently."

Jim Connor, a partner at London-based Morse, adds: "According to a recent study that we conducted, traditional managers will continue to use OTC derivatives, such as interest rate and inflation rate swaps, as part of their LDI and other risk reduction strategies. However, I think there will be a polarisation in the market between the ‘vanilla' products and the more complex and sophisticated bespoke products. This is mainly because of the cost to manage/process these instruments and fears over counterparty risk.

"I think overall, the buyside will improve their whole risk management framework. What happened last September and October was a real eye-opener and gave institutions the proverbial kick they needed to view risk on the same footing as returns."

Institutions also broadly welcome the recommendations in the ICAP report, which emphasise making better use of the existing OTC market infrastructure "which has been battle tested" and shown to operate "effectively in times of stress" rather than building new capabilities. ICAP believes that the initiatives (see box) it proposes would both "reduce the operational, contingent credit and markets risks" as well as enhance the "auditability and processing capacity" of the markets. Many of the initiative are already being adopted.

For example, electronic trading improves price transparency and the supervision of trading. Several of the larger more homogeneous OTC derivatives have gone down this route with CDS being the largest proponent. According to ICAP, about 80% of all credit default swap indices and 50% of single-name credit default swaps are traded electronically, compared to none two years ago.

"There already are some types of OTC derivatives being traded electronically but there is more capacity to do so," comments Susan Hinko, global head of industry relations at Tri-Optima, a post-trade processing services provider. "One of the main advantages is that it is a much more transparent way of doing business, than using a voice broker."

ICAP's suggestions of encouraging more portfolio compression and reconciliation have also been heeded. For example, TriOptima's reconciliation product, triResolve is now regularly reconciling more than 60% of all collateralised OTC derivative transactions globally, up from 40% in June. Viktor Johannsson, triResolve business manager, says: "In these times of market stress users of triResolve have been actively reconciling their positions. It enables them to respond immediately to disputes and manage their credit exposures effectively. In the past, participants took a more reactive approach."

Also, market participants have agreed to shorten the time it takes to settle trades, and there are industry-wide calls for the creation of a central counterparty to further reduce counterparty risk.

A significant share of interest-rate swap trades are cleared through SwapClear, which is part of LCH.Clearnet Group, while the oil derivatives market is cleared through either Nymex Clearport, owned by CME Group, the world's largest futures exchange or Ice Clear, part of International Exchange, reports ICAP.

For now, the battle rages on to develop a single CCP infrastructure. The main contenders seem to be International Exchange which bought Creditex, an inter-dealer credit derivatives broker as well as the Clearing Corporation (TCC), a bank-operated clearing house, and CME which struck a deal with Citadel, the hedge fund, to form an electronic marketplace with CCP clearing for CDSs.

ICAP white paper recommendations

Wider adoption of electronic trading because it creates greater price transparency, enables simpler and faster trade capture, affirmation and confirmation and easier supervision of trading activity. Quicker settlement cycles in all securities markets - a T+1 settlement cycle for all securities markets should be mandated. Faster and automated affirmation/confirmation of all derivatives trades and accelerated as close as possible to the trade date. Greater use of pre-booking netting - in many cases, transactions can legally and economically be netted, rather than settled on a gross basis. Wider adoption of central counterparty (CCP) or central clearing for OTC derivative markets. Those markets that do not already operate a central counterparty should introduce a CCP/clearing house that is independent of the trading platforms for those markets. More regular and comprehensive reconciliation of OTC trade details and valuations between counterparties should be mandated. This strategy should also apply to the compression of derivative portfolios, ideally on a multi-lateral basis.

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