The global OTC reforms have been well published and there is a high level of industry awareness of the requirements and operational implications. However, the impacts are yet to be fully identified and could have material consequences on the use of these instruments. In the extreme the reforms could spell the end of the OTC market for many managers.
Background To Reform
As a consequence of the GFC, the G20 held the view that the growth of the relatively unregulated OTC market had contributed to the crisis through a lack of transparency and standardisation of these transactions. In June 2012 the G20 reaffirmed their 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 end-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
The main components of reforms articulated by US and European regulators can be summarised as follows:
- Standardised OTC derivatives should be traded on exchanges or electronic platforms
- Standardised OTC derivatives should be cleared through central counterparties
- OTC derivative contracts should be reported to trade repositories
- Non-centrally-cleared derivative contracts should be subject to higher capital requirements.
The timing of these reforms depend on the size of the market participant but generally most investment managers will be required to comply by the end of 2013.
Although Australian regulators have not mandated central clearing for Australian issued securities, the global reach of offshore regulations, particularly those emanating from the US, mean local investment managers may be caught by the more rigorous offshore regulations.
Implications of Global Reforms
The application of global, particularly US reforms, is yet to be fully understood but 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 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’ or ‘Major Swap Participant’ 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.
Whilst it is not yet known what local counterparties will fall into these categories it is understood the most major local banks are registering in order to enable them to trade US based OTC’s.
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 order to trade the security, the investment manager will need to find and appoint a central 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.
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 they can’t access the collateral required by the CCP.
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.
We undertook a survey of local investment managers to assess their views on the likely impacts of OTC reforms. The results suggest that, whilst there is a good understanding of the pending OTC reforms there is concern on the indirect implications. Of the managers surveyed:
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 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 standardized model that is analogous to the listed derivatives process and those instruments that remain outside may become un-economic. So the question remains, do OTC reforms spell the end of the OTC market for investment managers?
Bruce Russell, Director
Wiliam Wenkart, Managing Consultant