Futurisation of the OTC market
The world of derivatives, particularly over-the-counter (OTC) derivatives, is in a state of change.
Prior to the 2008 financial crisis the derivative world consisted of:
- the OTC markets which traded bi-lateral, customised swap and options contracts via broker/dealers either by voice or, increasingly, by electronic trading platforms; and
- regulated exchange-traded derivative which trade standardised, cleared futures and options contracts via electronic trading platforms.
Over the years both types of derivative markets have seen many changes. Exchanges have demutualised and introduced electronic trading; the OTC derivative markets have embraced; a degree of standardisation, their own version of electronic trading and in some instances voluntary clearing. A number of these developments, particularly standardisation and clearing, have moved the OTC markets closer to the exchange model of trading. These changes have been brought about by technological advancements and commercial desires to capture additional volumes and revenues.
This trend has been helped along by a number of regulated exchanges, i.e. CME; ICE; NYSELiffe, gradually moving into the OTC space to try to gain control of this enormous and lucrative market. This in turn has prompted traditional voice brokers to launch their own electronic trading platforms in competition. However, following the 2008 financial crisis changes are now being imposed on the OTC markets in the form of Dodd Frank Act in the US and European Market Infrastructure Regulation (EMIR) in Europe.
While the two sets of regulations differ in detail, the general direction is the same; to tighten control over the trading, reporting and clearing of standardised “plain vanilla” swaps.
Trading of all OTC derivatives, with standardised contract specifications, must now take place on either a regulated exchange or on an electronic trading venue known as organised trading facilities (OFT) in Europe or swap execution facilities (SEF) in the US.
Trade details i.e. price and volumes must be reported to a central organisation called a swap data repository (SDR) and finally, all trades that can be cleared should be cleared through a willing central counterparty (CCP), who will be responsible for setting collateral or margin requirements.
These regulations are designed to bring transparency to a previously opaque market and prevent a repeat of the 2008 crisis and the situation that developed with AIG where it was far from clear who its counterparties were or the pricing methodology used in their OTC contracts.
As a consequence of these new regulations we now have what is being termed the futurisation of the swaps market. In its simplest form futurisation is the migration of traditional bi-laterally traded, customised OTC contracts into standardised contracts, similar to exchange traded future contracts, that are traded on electronic trading platforms and capable of being cleared through a CCP.
For OTC contracts traded through electronic platforms connected to a regulated exchange such as ICE, CME etc this is a relatively straight forward process. Following a period of consultation with its members, ICE converted all of its cleared OTC energy contracts, to economically equivalent futures contracts in October 2012 effectively by the stroke of a pen. These once OTC contracts are now subject to the rules and regulations of ICE Futures Europe and ICE Clear Europe.
However, these migrations still leave a sizeable proportion of the market trading on OTF/SEF’s. In order to trade on an electronic platform the contracts need to be standardised and then cleared by a willing clearing house. These newly designed, standard contracts are now being termed swap futures due to their resemblance to exchange traded futures contracts. Inevitably, some swaps will remain OTC (bi-lateral and uncleared) due to their customised contract specifications.
Regardless of whether the contracts are swap futures and cleared through a CCP or are pure swaps, collateral will need to be posted either with the clearing house or between the two counterparties. For cleared swap futures this collateral amounts to the maximum one day price movement for the underlying asset. For pure swaps, with no CCP, the collateral must equal the maximum price movement over a five day period. This obviously puts pure swaps at a financial disadvantage.
As with most new regulations there are always unintended consequences, not least regulatory arbitrage between different regions with different regulatory requirements. Standardisation of contracts, so they can be traded electronically and cleared through a CCP, also means that they become a one-size-fits-all contract.
This in turn will introduce risk and volatility into markets, particularly energy and commodity markets, which was not there previously. The proliferation of electronic OTF/SEF could also result in a loss of liquidity as fewer contracts are traded on more and more platforms. And finally trading electronically removes the human contact element of OTC trading and could result in the death of relationship banking.