Preserving the benefits of OTC derivatives while improving transparency and reducing risk will be a challenge in 2009.

Some observers maintain that widespread use of OTC derivatives led to the uncertainty that brought about the collapse of Lehman Brothers in September 2008 and accelerated the global financial crisis. The chaos in the world’s financial markets during the latter part of last year has brought intense scrutiny to OTC derivatives markets and prompted calls for increased regulatory oversight. Inevitably, the OTC market will change in 2009 in such a way that could present central counterparty clearing opportunities for exchanges.

OTC derivatives are customized financial instruments bilaterally traded between firms, some of which are regulated. The terms of the contract – including maturity dates, notional amounts, specifications and trading and credit procedures – are privately negotiated by the trade counterparties. The deals may be transacted across jurisdictional boundaries, and typically they are governed by contracts based on International Swaps and Derivatives Association (ISDA) master agreements.

For various reasons OTC derivatives are perceived as being more risky and opaque than standardized, exchange-traded futures and options contracts. For starters, these contracts are transparent because they are regularly marked to market. OTC contracts may or may not be marked to market depending on the contract and counterparty’s policy, and price quotes can vary significantly between dealers. In addition, these contracts are cleared by a central counterparty, which reduces default risk. Some OTC contracts are cleared centrally, but not all.

A declaration issued at the meeting of the G20 group of countries in November 2008, and reinforced in April, called for greater transparency in the OTC derivatives markets. The group made a commitment to strengthening market transparency by enhancing required disclosure on complex financial products and ensuring complete and accurate disclosure by firms of their financial conditions. It stated that there should be incentives to avoid excessive risk-taking.

Speaking at a Frankfurt conference, European Commissioner for Internal Market and Services Charlie McCreevy explained that the European Commission supports a comprehensive approach to international reform in order to avoid crises in the future. Such an approach entails strengthening of international regulatory standards; international cooperation between financial supervisors; multilateral macroeconomic surveillance and crisis prevention; and fortifying international crisis management and resolution capabilities. The Financial Stability Forum and the International Monetary Fund need to be strengthened, their effectiveness and legitimacy must be improved, and they must be encouraged to collaborate more closely.

“We need to take urgent steps to bring OTC derivative trading out from the shadows,” said McCreevy. “We cannot let the OTC market continue without adequate counterparty clearing.”

In an address hosted by the NASDAQ OMX Stockholm office in December 2008, Stefan Ingves, Governor of Sweden’s central bank, Sveriges Riksbank, said a central counterparty provides safer and more efficient securities settlement. The transactions can be netted out, and the counterparty is known. The counterparty risks can be managed by the central counterparty obtaining collateral. Moreover, the central counterparty has its own financial resources.

Despite these advantages, there is also a downside to central counterparty clearing. “The drawback with a central counterparty is that the market risks are concentrated to a single player – a high concentration of risk,” Ingves warned. “Provided the operations are properly organized, however, this is not a problem.”
 

Andy Nybo, a Senior Analyst at financial markets research and advisory firm TABB Group, argues that it is the lack of transparency rather than the OTC derivatives themselves that is the problem. “Derivatives are always like a stepchild when there is a market implosion or disturbance,” he says. “While the finger is often pointed at OTC and equities derivatives as the problem, these instruments devolved for particular purposes.”

OTC derivatives provide substantial benefit to the capital markets. By allowing risk to be transferred, firms can access markets and deploy capital to take positions or manage risks on their books. Further, OTC derivatives are not transparent for an important reason: investors want anonymity.

Sandy Frucher, Vice Chairman at NASDAQ OMX, agrees that investors have been attracted to OTC derivatives because of their lack of transparency, but tradeoffs have to be made. “What we have learned over the past year is that the risks of these instruments to the world’s financial markets are too great,” he says. “It is likely that reform of OTC derivatives will be high on the agenda for the new Obama administration.”

But it will not only be regulators who sort out OTC derivatives. Kevin Rideout, Global Head of Market Infrastructures at Citi Global Transaction Services, says massive steps are being made by market participants to clear up the mess. “There are RFPs flying around all over the place for CCPs to step up and novate OTC derivatives,” he says. “Like it or not, the regulators will have to put their foot down and make their mark on this space. It will be a much more regulated marketplace than before.”

Market players would prefer principle-based governance to rules-based governance. A principles based approach establishes a top line goal and allows individual firms to work out how to get there as long as they do not violate the larger principle. Ultimately, this model is more conducive to innovation, and it allows new products to be introduced quicker. In a rules-based approach, the regulator sets a standard and all firms have to comply with it.

Regardless of which approach is taken, it is likely that regulators will be more proactive in the coming year in forming policies that will push the OTC markets into a more transparent trading environment. In the meantime, the industry is working to develop solutions that can better manage the trading and pricing of OTC instruments as well as the creation and management of central clearing facilities that can handle the requirements of the OTC equity derivatives marketplace.
 

By Heather McKenzie ILLUSTRATION ANNA SVANFELDT