Towards transparency – Moving OTC derivatives onto exchanges

Contributor: Jennifer Hanes

As the  over-the-counter derivatives video points out, at $700 trillion the notional value of the global OTC derivatives market is ten times the size of global GDP, generating an estimated 20 million back office events annually.  The majority of these transactions are bilateral, and only a fraction clear through exchanges today.  However, with pending regulation forcing more of these transactions onto exchanges, market participants and industry analysts estimate that over the next few years anywhere from 45% to 80% of these transactions will be cleared through exchanges.  That’s a pretty significant shift, and one that will require major operational changes for both the buy and sell side.  Today, CME, ICE Trust and LCH. Clearnet are clearing ever larger volumes of interest rate and credit default swaps, and that is only expected to increase.

Two key advantages to clearing OTC derivatives on exchanges are reduced operational risk and increased accuracy.   ISDA has estimated errors for as many as 10% of OTC derivative trades;  no surprise given the bilateral and nonstandard processing in this relatively opaque market.   Certainly, moving more of these transactions onto exchanges should reduce that error rate and improve efficiency.

In part because of the increased need for better visibility around margin and collateral, buy side participants are reassessing where they place their business, as well as changes needed within their own operations.  According to a recent study, 72% of buy side firms surveyed listed preparing for the new legislation as a top priority – but fully 64% don’t know if they have the right systems in place to support.  That’s largely due to lack of clarity around the final rules themselves.

Similarly, broker dealers are looking at the operational and technology investments necessary in order to meet the new regulatory and customer requirements.  Citigroup’s Global Transaction Services unit for example earlier this year announced the rollout of its OTC Derivatives Services, supporting the full life cycle from confirmation, settlement, valuation, collateral and margin management post trade.  Morgan Stanley also recently announced that it cleared OTC credit default swap transactions through the newly established ICE Clear Credit, formerly Ice Trust U.S., ICE’s North American credit default swap (CDS) clearing house.

While there have been delays in finalizing the complex and far-reaching regulations, buy and sell side market participants continue to make progress in analyzing and addressing the transformational internal operations and technology changes necessary for compliance with Dodd-Frank .

What steps has your firm made, and what is your state of readiness?

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