Even before the onset of the global financial credit crisis, regulators were concerned about inefficiencies in OTC derivatives trade processing. Over the last year, it has become apparent just how vulnerable the market is to systemic failure. Although the OTC derivatives markets’ infrastructure has coped quite well during the turmoil, an integrated operational infrastructure would bolster reliability and robustness. To this end, various participants are considering ways to reduce operational, counterparty and settlement risk. One of those ways is to have exchanges set up a centralized clearing facility for these products.

In its semi-annual Over-the- Counter (OTC) Derivatives Markets Statistics for the year ended December 31, 2007,

Although the OTC market has grown faster than the exchange-traded market, recent events have taken their toll. The failure of Lehman Brothers changed the landscape for derivatives users, says Martin Johnson, Investment Director at P-Solve Asset Solutions, a UK-based investment consultancy. “Until [recently] pension fund trustees who had attempted to mitigate their funds’ exposure to interest rate, inflation and equity market volatility by using derivatives probably had taken for granted that these contracts would perform their required function,” he says. “They may not have given enough thought to what might happen if their swap counterparty defaulted. After all, surely the big investment banks were too big to fail.”

Lehman Brothers’ bankruptcy highlighted the increased probability of counterparty defaults and the resulting operational issues for institutions with derivative contracts in place. Old contracts must be terminated in an orderly fashion, new contracts put in place at competitive rates and collateral calls managed regularly to minimize the potential impact of future market events.

Bob McDowall, a Senior Analyst at the European operations of financial research firm TowerGroup, says that he believes eventually OTC derivatives will have a higher risk weighting for capital purposes and regulators may provide some incentives for OTC derivatives to be cleared by exchanges. Already some exchanges are looking to provide confirmation matching of OTC derivatives that are not exchange listed. “If exchanges are prepared to make their post-trade services available to the OTC market, that could be a happy compromise,” he says. “By using the central counterparty [CCP] and post-trade technology services of an exchange, risks will be reduced.”

Momentum is building behind the idea of a centralized clearing facility for OTC derivatives, after years of manual processing. Speaking at the annual meeting of the Swiss Futures and Options Association in Switzerland in September, Mark Yallop, Chief Operating Officer of broker ICAP, said more OTC market trades would be cleared through a central clearinghouse in the next 12-18 months, given 'regulatory concerns.' On-exchange clearing would facilitate fast trade confirmation, and result in the cost of processing trades falling to as low as US$5, which would enable more OTC trading to take place.

Investment bank-backed clearinghouse The Clearing Corporation has announced its plans to launch a credit default swaps clearing platform before the end of the year. The facility will be a global initiative to clear both US and European CDS indexes, tranches and single-name liquid CDSs. Eurex Clearing aims to complement US initiatives with a European-based one and is evaluating the introduction of a CCP for OTC products.

The US-based International Derivatives Clearing Group (IDCG), a new derivatives exchange and clearinghouse, has applied to the Commodity Futures Trading Commission for a clearinghouse license. Set to launch in 2009, IDCG will focus on OTC traded instruments, primarily interest rate swaps. NASDAQ OMX has taken a minority interest in IDCG and will provide the clearing system.

The trend toward centralized clearing of OTC derivatives has not yet reached the Asia-Pacific region. Among the reasons for this trend is the strongly domestic nature of the markets; few have opened up to regional or more international trading. “In derivatives markets, the most efficient ones in the region are those that have adopted common clearing standards – Hong Kong, Singapore and Australia,” says Ulf Carlsson, General Manager for North Asia at NASDAQ OMX. “These markets stand out as being the most solid and international in terms of post-trade practices. They are using traditional risk-margining models and have set up CCPs and clear in real-time.”

Derivatives exchanges in countries like China, Korea and Japan have historically set up clearing facilities based on domestic standards, which, according to Carlsson, is a case of reinventing the wheel. “I think investors will force them to adapt to international standards and practices, particularly once countries take the steps to open up their borders.”

There is huge potential to grow the exchange-listed derivatives markets in Asia-Pacific, which currently represents only about two percent of the total global market. Regulatory requirements such as the need to hold margins in the local currency stand as a barrier to participation. Going forward, demands from the global players will likely have a significant impact on the derivatives markets in Asia.

Most indications point to continuing turmoil in the markets for the near term. Once the dust settles, the industry will need to work with regulators to restructure and, to some extent harmonize, the global financial infrastructure for OTC products. Some of this work has already begun especially in the US and Europe. As central counterparty clearing facilities, exchanges can leverage their technology to play a key role in reducing risk in the OTC markets.
 

BY HEATHER MCKENZIE   PHOTO NASDAQ OMX AND BANK FOR INTERNATIONAL SETTLEMENTS

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