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Central clearing of OTC derivatives is supposed to increase transparency and reduce systemic risk. But Richard Hemming finds that pension funds might be among those counting the costs

As US and European regulators prepare the way for standardisation of over-the-counter (OTC) derivatives, industry insiders say that in their haste, the needs of lower profile users of the market - such as the €4trn-plus European pension funds industry - are being overlooked.

Much of the concern rests on the need for OTC products to be cleared by a central counterparty (CCP). The CCP acts as a buyer to every seller in a transaction, ensuring that a transaction is completed if one party defaults. The use of CCPs is set to rise dramatically under US legislation passed in July that requires the vast majority of OTC derivatives to be passed through them. European legislation is not far off - a European Commission consultation on derivatives and market infrastructures closed in July, ahead of a detailed legislative proposal.

Pension funds that use highly specific and complex OTC derivatives will be among those that are most negatively affected by the changes, according to Mark Higgins, vice-president of global clearing and collateral management for BNY Mellon. "It's generally accepted that on an exchange OTC transactions are built for bulk," he says. "It's not suited for heavily structured products. There are central clearing parties that are rolling out throughout the world and their tendency is to focus on product types. It is generally known that not all derivative products fit on a CCP today."

The net effect is that costs of hedging will go up dramatically for pension funds because they do not use swaps and other OTC derivatives frequently. "The CCP adds an extra layer of costs and extra margin, if you are only trading a dozen swaps a year it may not justify itself," says Higgins.

Jon Anderson, head of valuations and OTC derivatives at fund administrator GlobOp Financial Services, agrees: "From the pension funds' point of view they are being tainted with the same brush as the banks," he says. "Pension funds are at the highest end of the food chain, because they deal with real assets and have high credit ratings, but that won't be reflected in the contracts they write."

Anderson says it is inevitable that pension funds will have to post more margin and collateral in the wake of the credit crisis, although the risk of insolvency is extremely low in comparison to other financial institutions.

But pension funds, like other financial entities will not be exempt from the use of CCPs unlike some companies in the US and Europe that are deemed to be important to the economy.

Anderson echoes the comments of others when he says that even though the costs will go up, derivatives will still be the most efficient mechanism for pension funds and insurers to hedge their liabilities, both long and short term. The issue of increasing costs for complex products however, is just the tip of the iceberg in terms of the problems that experts foresee. Other more serious long-term implications include the probability of another crisis due to over-reliance on clearing houses, accounting issues, as well as valuation and operational difficulties.

Right now, many of these issues are being sifted through by interested parties such as dealers, lawyers and banks. This is because the pronouncements by regulators have been at a very high level and are aimed at pacifying a public baying for blood after the credit crisis.

Most recently, arguably the world's most powerful regulator in derivatives, Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), indicated his confidence in effectively "commoditising" the world's OTC derivatives market in order to reduce the risk of another financial meltdown.

"The Wall Street reform bill will - for the first time - bring comprehensive regulation to the over-the-counter derivatives marketplace," he said after President Obama's signing of the Dodd Frank Wall Street Reform and Consumer Protection Act on 21 July. "Derivatives dealers will be subject to robust oversight. Standardised derivatives will be required to trade on open platforms and be submitted for clearing to central counterparties. The commission looks forward to implementing the Dodd-Frank bill to lower risk, promote transparency and protect the US public."

Regulators and politicians know that in the wake of the financial crisis, they must be seen to be doing something. And in the public's mind, much of the blame for the crisis lies at the doorstep of complicated OTC derivatives. Of most concern is the lack of transparency in a market where neither the authorities nor other market participants know of the underlying exposures or liabilities of any two parties in an OTC derivatives contract.

Various measures are being proposed that revolve around standardising OTC contracts; ensuring that they are traded on exchanges or electronic trading platforms and that all of them are cleared through central counterparties. It has also been recommended that those that aren't cleared are subject to higher capital requirements.

Supporting the case for reform is the fact that during the crisis those derivatives that were standardised and traded on exchanges did not fail. This is because a clearing house stood between the two parties in a trade, guaranteeing that the transaction was completed even if one party defaulted. And just as important, the clearing houses did not fail. The absence of a clearing mechanism in most of the OTC derivatives markets prior to the Lehman Brothers default was one of the reasons why the explosions in the financial system reverberated so widely.

The OTC derivatives markets constitute a massive part of the global financial system. Exchange traded futures and options only represent something like 20% of the overall derivatives market. The remainder is OTC. That gives them importance to the wider financial system. This point was burned into policy makers' minds in the aftermath of the collapse of Lehman Brothers in September 2008, which left many OTC trades incomplete and caused complete panic. The imaginations of politicians and regulators alike have been fired up by the idea that there will be containment of potentially systemic shocks to the financial system if there is more clearing.

"What authorities are concerned with is transparency; that what happens in OTC market is reported and companies can't run up huge positions without anyone knowing," says David Jenkins, the European Energy manager at Tradition, one of the world's top three inter-dealer brokers.

But Ruben Lee, CEO of consulting firm Oxford Finance Group, says that while this may be what they want, they are going about it the wrong way. "Is forced clearing of OTC derivatives beneficial?" he asks. "My view is it is not. Which is not to say that more clearing is not positive."

Invariably some OTC derivative products will be cleared that should not be cleared. If one party defaults then the clearing house may not be able to manage the risks. In the end the regulator will be blamed for forcing clearing in such a product. Lee acknowledges that clearing delivers benefits - including anonymity, netting, good risk management and reduction in the number of settlements. For clearing to work, however, there must be transparent pricing and reasonable liquidity in the contracts being cleared, according to Lee, and when authorities mandate products to be cleared that are not sufficiently transparent or liquid, problems will occur.

"Will the regulator when deciding [which products will be cleared] act in the appropriate manner and assess the transparency and liquidity of those products?" he asks. "No, they don't have the right incentive to do so. The result is that some of these products will have difficulty being cleared in the future. The point of mandated clearing is to reduce systematic risk, but it will actually embed more systematic risk."

At the operational level the OTC market for derivatives has changed a great deal as participants seek to reduce counterparty risk. This introduces a whole new set of risks for the market. "Since the economic crisis we have seen static volume but lower overall value, because players are buying more contracts for smaller value," observes Steve Ingle, global derivatives product manager at BNY Mellon Asset Servicing. "A deal worth £1bn would primarily have been done with one counterparty, but now the deal is split with five counterparties." This leads to a need to monitor many more counter parties and their collateral for any particular transaction. Ingle says that this represents a problem for the majority of his clients, which are mainly asset managers and pension funds. "From a servicing perspective it's a risk to clients because they don't have the expertise or the infrastructure to deal with this."

The key problem that crops up in relation to creating standardised OTC products is valuation; by definition these products may have little or no value beyond what the holders attach to them. "It's how you value an OTC product that counts, as the valuation is theoretical; if the holder is a pension fund and it matches their liability 50 years hence, then the value is in the net effect on the portfolio, not today's modelled value for the product," says Ingle.

On the issue of valuation, Roger Liddell, CEO of UK-based clearer LCH.Clearnet, is adamant that accurate valuation is possible for even the most exotic of derivative instruments. "Many derivative products are not sufficiently traded so that an observable price cannot be found," he says. "[But] with these products you use a high yield curve to value all the cash flows. You can value each cash flow any day by marking them against a yield curve."

Liddell admits that it will take some time before OTC markets become ‘commoditised', considering their massive scale. In interest rate swaps for example, he estimates that Clearnet has a 40% market share in the clearing business of a total notional market worth $225trn (€171.9trn).

"In terms of the scale of activity, on any given day the total number of trades is 750 and this spans across 14 different currencies and spans across differing maturities, which gives you a sense of how individual these contracts are," says Liddell. "The dynamics you need for a listed trading market are likely to happen over time, but certainly not over night."

Liddell says that clearing should help bring costs of OTC trades down very significantly because risk reduction and increased transparency will promote competition. "Customers will be eliminating counterparty risk which is huge when you have long-dated liabilities," he suggests. "This needs to be seen as one stage where markets are becoming more commoditised."

But it is the here-and-now that pension funds are dealing with. Barb McKenzie, the COO for Principal Global Investors which manages about $222bn, says that the uncertainty in the marketplace due to legislation means that her pension fund clients are not doing as much hedging. "Things are getting more clear, but they're not really clear," she says. "There is little clarity around legacy trades - trades that are already on the books. The law is silent on this point."

The big ‘unknown' is whether or not the accounting rules will be revised to reflect regulatory changes in the derivatives market. For those who hedge, there will be pressure to move to instruments that are centrally cleared, rather than doing more exact hedges with customised swaps. Current accounting rules tend to force the use of more customised trades in order to qualify for hedging accounting treatment under US GAAP and other standards. There needs to be a review of the rules, which arguably drove an increased volume of swap transactions and may now make hedging with derivatives impractical.

And as the market changes, so do the institutions charged with operating it. As the business of clearing expands, there is an tendency for this business to merge with others as companies see the dollar signs. "The difference between clearing houses, OTC inter-dealer brokers and exchanges is becoming blurred," says Jenkins. "You have exchanges buying clearing houses and OTC brokers trying to buy clearing houses and even exchanges. The old days of saying we're an exchange, or we're an OTC broker, or we're a clearing house are very much gone."

With this in mind, policing of the giant derivatives industry could prove to be a bigger headache than the "well-meaning" politicians had imagined.
 

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